Two ways interest can accumulate
Simple interest is calculated on a specified principal amount rather than on interest previously added to that amount. Compound interest includes eligible accumulated interest in the base for later calculations. Compounding is familiar in savings, but it can also matter for some borrowing arrangements when interest is capitalized.
Neither label alone describes the complete cost of a loan. Many installment loans calculate interest on a declining outstanding balance, which is different from using the original principal throughout the entire term. Whether unpaid interest may be added to a loan balance depends on the contract and law.
A carefully limited example
Imagine a balance of 10,000, a stated annual rate of 6%, no repayments or fees and a one-year period. Under a simplified simple-interest calculation on unchanged principal, interest for that year is 600.
If interest is added to the balance after six months and then earns interest for the second six months at 3% per half-year, the illustrative ending balance is 10,609. The extra 9 comes from charging interest on the 300 added after the first period. This example ignores day counts, payment timing and real product terms; it is not a loan offer or a forecast.
How loans usually complicate the comparison
For a conventional amortizing loan, borrowers make payments during the term. Because principal falls, later interest is often calculated on a smaller balance. The payment schedule, not a single flat-interest example, is needed to know the total cost. A product described as having a fixed interest rate can still use periodic compounding conventions or different repayment allocation rules.
Interest can also be capitalized after certain deferrals or under other contract conditions. That can increase the principal on which later interest is calculated. Borrowers should distinguish ordinary interest accrual, adding unpaid interest to the balance and charging late fees: these are not interchangeable concepts.
What to inspect in an agreement
- Interest base: original principal, current balance or another amount?
- Accrual interval: daily, monthly or another convention?
- Capitalisation: can unpaid interest become principal, and when?
- Payment application: how do repayments affect the interest-bearing balance?
- Effective cost: does a quoted rate include fees or only interest?
A higher rate does not automatically imply compounding, and a lower rate does not prove a lower total cost. Compare actual cash flows and disclosures for the same amount and term.