Linear interest is the simplest form of interest, in which the amount of interest earned or paid is directly proportional to the principal. In other words, linear interest is calculated by multiplying the principal by the interest rate. For example, if someone has a loan with a 5% linear interest rate and a $1,000 principal balance, they will owe $50 in interest at the end of the year.
Linear interest is often used in simple interest loans, which are loans with a fixed interest rate that does not change over time. In contrast, compound interest loans have an interest rate that changes over time, and the amount of interest earned or paid is based on the current principal balance plus any unpaid interest from previous periods.
While linear interest is simpler to calculate than compound interest, it can disadvantage borrowers because it means they will pay more interest over time. For example, a borrower with a $1,000 loan and a 5% linear interest rate will owe $50 in interest at the end of the first year. If they don't make any payments on the loan, the principal balance will grow to $1,050 at the end of the second year. This means they will owe $52.50 in interest at the end of the second year, and so on.
In contrast, a borrower with a $1,000 loan and a 5% compound interest rate will only owe $51.25 in interest at the end of the first year. This is because the compound interest rate considers both the current principal balance and any unpaid interest from previous periods. As a result, borrowers with compound interest rates typically pay less interest over time than those with linear interest rates.
Linear interest can benefit lenders, however, because it means they will receive a steadier stream of interest payments over time. This can be helpful in cases where the lender needs to rely on the interest payments to cover their own costs, such as when providing loans to small businesses.
Overall, linear interest is the simplest form of interest to calculate, but it is not always the most advantageous for borrowers. Borrowers should consider both linear and compound interest rates when taking out a loan, and decide which option is best for their individual situation.
A visual guide to simple, compound and continuous interest rates
When deciding what kind of interest rate to agree to, it's important to understand the difference between simple, compound and continuous interest. Here's a quick guide to help you out.
Simple interest is calculated only on the principal amount of a loan and not on any accumulated interest from previous periods. This means that with simple interest, your monthly payments will stay the same throughout the life of the loan.
Compound interest is calculated on both the principal amount of the loan and on any accumulated interest from previous periods. This means that your monthly payments will increase over time as you pay down your loan, because more of each payment will go towards interest as opposed to principal.
Continuous Compound Interest
Continuous compound interest is similar to compound interest, but the interest is calculated and added to the principal balance every day rather than once a month. This means that your monthly payments will increase even more over time, as the total amount of interest you owe will grow at an accelerated rate.
Ultimately, which type of interest rate is best for you depends on your individual circumstances. If you're comfortable with your monthly payments increasing over time, then compound or continuous compound interest may be a good option for you. But if you want to keep your monthly payments stable, then simple interest may be a better choice.
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