Two loans can advertise the same 24% rate and still cost very different amounts. The difference comes from what the rate is applied to, how often interest is added to the balance, and how repayments bring that balance down.
Lenders need to understand this to price loans correctly and explain them clearly. Borrowers need it to compare offers and to know what an early repayment or a missed installment will do to what they owe.
This article explains simple interest, compound interest, flat-rate loans and reducing-balance loans with worked numbers, shows why the quoted rate rarely tells the full story, and ends with seven steps for working out the true cost of a loan.
What simple interest means
Simple interest is interest that never earns interest. The basic formula is principal × annual rate × time in years. Take a loan of 200,000 at 24% a year for one year. The interest is 200,000 × 0.24 × 1, which comes to 48,000, so the borrower owes 248,000 at the end of the year if nothing is repaid earlier.
There is a choice hidden in that formula. A loan can charge simple interest on the original amount for the whole term, or only on the amount still owed. In the second case, interest shrinks as the borrower repays.
For example, a lender that charges interest daily on a 200,000 balance at 24% takes about 131.51 a day, and that figure drops as the balance drops. The term “simple interest” does not tell you which version a loan uses, so the contract has to say.
What compound interest means
Compound interest adds accrued interest to the balance, so the next period’s interest is charged on the principal plus the interest already added.
The formula is A = P(1 + r/n)^(nt), where P is the principal, r is the annual rate, n is the number of compounding periods a year and t is the number of years.
Now run the same 200,000 loan at 24%, compounded monthly, with no repayments. Each month’s interest is 2% of the balance.
Month one adds 4,000, so the balance becomes 204,000. Month two adds 4,080, which is 2% of 204,000, and the balance reaches 208,080.
After twelve months the balance is about 253,648. That is about 53,648 in interest, compared with 48,000 under simple interest. Monthly compounding also raises the effective annual rate to about 26.8%.
Compounding is rarer in installment loans than most people think. A loan can charge interest daily and still be simple interest, as long as the lender collects the accrued interest instead of adding it to the principal.
Compounding begins when unpaid interest joins the balance and starts earning interest itself. That usually happens on revolving credit, or when a contract lets the lender add overdue interest to the balance.
Simple interest vs compound interest: the main differences
The two methods differ in the balance used to calculate future interest. Simple interest uses the principal, which is either the original amount or what is still outstanding, depending on the contract.
Compound interest uses the principal plus any interest already added to the balance.
Unpaid interest is treated differently. Under simple interest, it stays separate from the principal unless the contract adds it to the balance.
Under compound interest, capitalised interest raises future interest charges, because the lender now charges interest on that interest too.
Early repayment also works differently. With simple interest, repaying principal early reduces future interest when interest is charged on the outstanding balance.
With compound interest, early repayment can also reduce future interest, depending on the balance and the compounding rules.
Before you compare two loans, check two things. For simple interest, find out which principal the lender uses for each calculation. For compound interest, find out how often the interest compounds and when it joins the balance.
These are general methods. The exact cost of a loan also depends on its term, repayment frequency, fees and the rules for applying each payment.
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Flat rate and reducing balance
For installment loans, the bigger gap is usually between flat-rate and reducing-balance pricing. Both are forms of simple interest.
A flat rate charges interest on the original amount for the whole term, even though the borrower keeps repaying. A reducing-balance rate charges interest only on what is still owed.
Take the same 200,000 loan at 24% over twelve months, repaid in equal monthly installments. On a flat rate, interest is 48,000, the total repayment is 248,000 and each instalment is about 20,667.
On a reducing balance, each instalment is about 18,912, the total repayment is about 226,943 and interest is about 26,943.
The first month looks the same, with 4,000 of interest either way. After that, the reducing-balance loan charges less each month beca’use the balance keeps falling.
This means a 24% flat rate costs about the same as a 41.7% reducing-balance rate, roughly 1.7 times the number on the label.
MFTransparency, which tracks microfinance pricing, found the same pattern: a lender using declining balance would have to charge 56.3% a year to collect as much interest as one charging 36% flat.
Precomputed interest is a related setup. The lender works out the total interest at the start and builds it into the installments. The US Consumer Financial Protection Bureau notes that precomputed interest benefits the lender when a borrower pays early, because the interest was fixed up front.
Back to the 200,000 example: a borrower who settles after six payments owes about 105,934 on the reducing-balance loan. On the flat schedule, 124,000 of installments are still left, unless the contract gives a rebate.
Why the method matters to lenders
Interest income has to pay for funding, payment processing, identity checks, collections, staff, technology and expected losses. The calculation method decides when that income arrives and how much of it survives early repayment.
A reducing-balance loan earns less when a borrower repays early. A flat or precomputed loan keeps more of its scheduled interest unless the contract gives a rebate. Revenue forecasts and early settlement policies should account for that.
Borrower income matters too. In many markets, including across Africa, borrowers earn unevenly. A trader has good weeks and slow ones, a farmer earns mostly after harvest, and a salary can arrive late.
A borrower who misses an installment is often already stretched, and adding unpaid interest to the balance makes recovery harder.
Check whether local law and your agreement allow that, and set clear overdue rules: how interest is calculated on arrears, whether unpaid amounts are ever added to the balance, and how the borrower is told.
Showing borrowers the true cost
A quoted rate can make a loan look cheaper than it is, so lenders should also show the effective interest rate and the total repayment.
CGAP’s paper on microcredit interest rates defines the effective rate as what the client really pays, and it shows how fees and up-front interest push that rate above the stated one. Monthly rates add to the confusion.
A lender that advertises 2% a month is describing 24% a year. On the 200,000 loan, the borrower repays 248,000 on a flat basis or 226,943 on a reducing balance, a gap of about 21,057 for the same headline rate.
Borrowers can only compare offers fairly when the lender states the rate, the method, how often interest accrues, the instalment, the total to repay and every fee.
How software should handle the calculation
A lending platform has to use the chosen method the same way at every stage: building the schedule, posting repayments, settling early and making adjustments.
Lendsqr’s loan product settings let a lender pick between straight line, which charges interest on the full original amount, and reducing balance, which charges interest only on what is still unpaid.
A worked example in the documentation shows how the two schedules differ.
The day count convention setting controls how interest accrues across days, such as Actual/365, and the documentation notes that changing it can slightly raise or lower interest even when the principal, rate and loan term stay the same.
Whatever system you use, check that it supports the methods you sell. It should keep an audit trail of the opening balance, interest accrued, payments, fees and closing balance for each period, and it should handle late or duplicate payment notices without charging the borrower twice.
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How to calculate and compare loan interest
Step 1: Confirm the principal and the term
Find out how much money the borrower will receive and how long they have to repay it. Write the term in the same unit as the rate, whether that is days, months or years, so the two match.
Step 2: Identify the interest method
Ask how interest is calculated. The loan may use simple interest on the original amount, a reducing balance, a flat rate, precomputed interest or compounding, and the quoted rate alone will not tell you which.
Step 3: Confirm the rate and how often interest accrues
Check whether the rate is yearly or monthly and whether interest builds up daily or monthly. Then find out if unpaid interest can be added to the principal.
Step 4: Build the full repayment schedule
Write out every instalment, with the interest and principal in each one. The timing of payments changes the balance, so the whole schedule is the only reliable way to compare loans by total repayment instead of by rate.
Step 5: Add fees and other charges
Add origination fees, service charges, insurance and late-payment charges to the total. Interest alone rarely shows the full cost of a loan.
Step 6: Test early repayment and missed payments
Work through two cases. In the first the borrower pays early or pays part of an instalment, and in the second they miss an instalment. For each one, check how the contract treats accrued interest and fees.
Step 7: Explain the result
Give the borrower the installment amount, due dates, total repayment and all charges. Tell them plainly what happens if a payment is late and what they will owe if they want to settle early.
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What lenders and borrowers can take away from this
Simple interest charges interest on the principal. Compound interest charges it on the principal plus interest that has already been added.
The bigger difference often comes from how the rate is applied, to the original amount or to what is still owed, and the same advertised rate can cost a borrower much more or much less depending on that choice.
Lenders should state the method, the effective rate and the total repayment, test early repayment and missed payments before launch, and make sure their software calculates what the contract says.
Borrowers should ask for the total they will repay, and how early payment is treated, before they accept an offer.
