How to calculate loan interest: simple vs. compound vs. flat

Every loan product is built on an interest calculation method, and the method you choose changes both what the borrower repays and how forgiving the schedule is if a payment slips. The three names that come up most are simple, compound and flat interest. They are related, not interchangeable, and the confusion between them is behind many disputes about what a loan "really" costs.

This article compares them on one example and explains where each fits. For the full set of methods including reducing balance and interest-only, see how to calculate loan interest.

Simple interest

Simple interest is calculated only on the original principal, for the time the money is outstanding:

Interest = Principal × Rate × Time

For 1,000 at 12% a year for 3 years, interest is 1,000 × 0.12 × 3 = 360, and the total owed is 1,360. Interest is the same each year (120) because it is never charged on earlier interest.

Simple interest is predictable and easy to explain to a borrower, which is why it is common for short-term loans and group loans, where transparency matters as much as the math. It describes how interest is earned, not how the loan is repaid. A loan can accrue simple interest and be repaid in a lump sum, or in installments, and the installment structure then decides how the loan behaves.

Compound interest

Compound interest is charged on the principal plus any interest already added:

Amount = Principal × (1 + r)^n

The same 1,000 at 12% for 3 years gives:

• Compounded annually: 1,000 × 1.12³ = 1,404.93, so interest is 404.93
• Compounded monthly (1% a month): 1,000 × 1.01³⁶ = 1,430.77, so interest is 430.77

Compare that with simple interest's 360. The extra 44.93 or 70.77 is interest earned on interest, and the more often interest compounds, the larger it gets. Compounding is the norm for savings and deposits, where it works for the customer, and it appears on loans where interest accrues and is added to the balance, such as a loan repaid in one payment at the end.

For borrowers, compound interest means the cost of an unpaid balance grows over time, which is why a loan left to accrue for a long period can become much larger than it started.

Flat interest

Flat interest applies the simple-interest formula once, for the whole term, and divides the total by the number of installments. For 1,000 at 12% flat for 12 months:

• Interest = 1,000 × 12% × 1 = 120
• Total = 1,120; installment = 1,120 ÷ 12 = 93.33

The borrower repays principal every month but is charged interest as if they owed the full 1,000 all year. The real annual cost is about 21.5%, not 12%. Our guide to the effective interest rate on flat rate loans shows how to work that out.

The three side by side

The flat rate example over three years is 360 in interest, the same as simple interest, but paid down in installments over 36 months, so the borrower's average debt is much lower than 1,000. That is why the effective rate is so much higher than 12%.

Which method is right for which loan?

• Short loans and group loans often use simple or flat interest for their clarity. If you use flat, disclose the total to repay.
• Longer loans are fairer on reducing balance terms, where interest is charged on what is still owed. See flat rate vs reducing balance interest.
• Loans that accrue without periodic payments use compound interest, and the agreement should state how often it compounds.
• Short bridging loans may use interest-only terms, with the principal due at the end.

How these map to LoanTabs

Simple interest is a way of thinking about the calculation, and in LoanTabs a lender implements it through one of the methods a loan product offers: flat, declining balance, reducing balance (equal installments or equal principal), interest-only, or compound (accrued, or with equal installments). Each loan product fixes one method, and interest can be a percentage or a fixed amount, charged per day, week, month, year or loan cycle. The loan management features page describes product setup, and the schedule preview when you create a loan shows the result before you save.

Mistakes to avoid

• Confusing the label and the cost. "12% flat" and "12% compound" are very different loans.
• Not saying how often interest compounds. Daily, monthly and annual compounding produce different totals.
• Skipping the total repayable. Always show the borrower what they will pay in currency.
• Using one method for every product. Match the method to the loan's size, term and borrower.

FAQ

Is flat interest the same as simple interest?

Flat interest uses the simple interest formula, but applies it to the original principal for the full term and splits it into equal installments. That makes the effective rate much higher than the quoted rate.

Is compound interest always higher than simple interest?

For the same rate and time, yes, once there is more than one compounding period. The more often interest compounds, the higher the total.

Which interest method is cheapest for the borrower?

Reducing balance, because interest is only charged on what is still owed.

Does LoanTabs support simple interest?

Simple interest is implemented through the loan product's method: flat, declining or reducing balance, or interest-only, depending on how the loan is repaid.