Quick summary

Different accrual methods change both the timing and the size of interest charges. Simple interest charges only on the principal; compound interest charges on principal plus previously accrued interest; amortization spreads principal and interest across scheduled payments so early payments are interest-heavy. Small differences in method or compounding frequency can add hundreds or tens of thousands of dollars over a loan’s life.

Why accrual method matters

A loan’s interest accrual method determines three things borrowers care about most:

  • How often the lender adds interest (daily, monthly, annually).
  • Whether interest itself will be included in future interest calculations (compounding).
  • How your payments are split between interest and principal (amortization schedule).

Those mechanics change your outstanding balance, the interest portion of each payment, and the total interest you pay over time. The Consumer Financial Protection Bureau explains that loan contracts must disclose how interest is calculated; borrowers should read those terms before signing (Consumer Financial Protection Bureau).

Key accrual methods, explained (with formulas and examples)

1) Simple interest

  • How it works: Interest = Principal × Rate × Time. Interest is calculated only on the outstanding principal for the period and does not itself accrue interest.
  • Typical uses: Auto loans sold as “simple interest” loans, some personal loans, and short-term loans.
  • Example: $5,000 at 8% simple interest for 3 years: Interest = $5,000 × 0.08 × 3 = $1,200; total repayment = $6,200.
  • Practical note: Simple interest loans can still grow if you skip payments, because unpaid interest may be capitalized (added to principal) under the contract.

2) Compound interest

  • How it works: A = P × (1 + r/n)^(n·t), where P = principal, r = annual rate, n = compounding periods per year, t = years. Interest earned in one period becomes part of the base for the next period.
  • Typical uses: Savings accounts, many investment products, and some consumer loans where the contract specifies compounding frequency.
  • Example: $5,000 at 8% compounded annually for 3 years: A = 5,000 × (1 + 0.08/1)^(1×3) ≈ $6,382; interest ≈ $1,382.
  • Why compounding frequency matters: The higher the compounding frequency (daily vs monthly vs annually), the more interest accumulates. The Federal Reserve’s materials on interest and rates explain this relationship between rate, frequency, and effective yield (Federal Reserve).

3) Amortization (loan amortization)

  • How it works: Amortized loans use a fixed or scheduled payment that covers both interest and principal. Early payments mostly cover interest; later payments apply more to principal. The periodic payment for a fully amortizing loan can be calculated with the loan payment formula (using rate per period and number of periods).
  • Typical uses: Mortgages, many installment loans.
  • Example (30-year mortgage, simplified): For the same nominal rate, a 30-year amortized loan will show high total interest because interest accrues on a large outstanding principal for many years, even though monthly payments remain level.
  • See more: FinHelp’s guide on Understanding Loan Amortization: Principal vs Interest explains schedules and how payments shift over time.

4) Other accrual patterns to watch

  • Negative amortization: Monthly payments are less than the interest due, so unpaid interest is added to principal. This increases what you owe unless corrected. See the FinHelp post on Loan Amortization Types: Fixed, Graduated, and Negative Amortization for context.
  • Per-diem (daily) interest: Interest accrues each day; lenders sometimes show a per-diem rate for payoff quotes. Daily accrual can raise costs if you hold a balance every day.
  • Rule-of-78s (front-loaded interest): An older method that allocates more interest to early payments; mostly obsolete for many consumer loans but may still appear in legacy contracts.

Side-by-side numeric comparison

Borrower A: $5,000 — 8% simple interest — 3 years → Total paid ≈ $6,200.
Borrower B: $5,000 — 8% compounded annually — 3 years → Total paid ≈ $6,382.
Borrower C: $200,000 mortgage — same interest rate but amortized over 30 years → monthly payment and total interest depend on the amortization schedule; amortization typically results in greater lifetime interest than a short-term simple-interest loan at the same nominal rate.

These examples show why you can’t compare loans by the nominal rate alone; accrual method and term length are just as important.

Contract language to inspect before you sign

  • Compounding frequency: daily, monthly, quarterly, or annually? More frequent compounding increases interest.
  • When interest is capitalized: after deferment or missed payments? Capitalized interest increases principal and future interest.
  • APR vs interest rate: APR includes some fees but won’t tell you compounding frequency. Use APR to compare cost but read the full accrual terms.
  • Prepayment rules: Are extra payments applied to principal immediately, or held in a suspense account? Are there prepayment penalties?

Practical strategies to reduce total interest

  • Make extra principal payments when possible: For amortized loans, even small extra principal payments reduce future interest (see FinHelp’s Loan Amortization Hacks: Paying Off Principal Faster).
  • Increase payment frequency: Paying biweekly or making an extra monthly payment each year trims interest for amortized debt (see FinHelp’s article on repayment frequency).
  • Refinance when rates drop or if a different accrual structure is cheaper: Moving from a variable-rate, frequent-compounding loan to a lower fixed-rate loan can save money, but include refinancing costs in your calculation.
  • Avoid deferred interest traps: “No interest if paid in full” promotions often capitalize interest if the balance isn’t repaid on time—read the fine print.

How to compare loans correctly

  1. Confirm the nominal rate and the compounding frequency. 2. Compare effective annual rate (EAR) or use an amortization schedule that shows total interest. 3. Include fees and term length — sometimes a slightly higher rate with a shorter term costs less overall. 4. Use spreadsheet functions (RATE, PMT, EFFECT) or an online calculator and confirm assumptions about compounding and payment timing.

Tax and reporting notes

Interest treatment for taxes depends on loan type. Mortgage interest may be deductible for taxpayers who itemize—see IRS guidance on mortgage interest deduction. Student loan interest may also qualify for tax benefits subject to IRS rules. Always confirm current details with the IRS or a tax professional (irs.gov).

Common mistakes and misconceptions

  • Assuming APR tells the whole story: APR doesn’t indicate compounding frequency or when interest is capitalized.
  • Believing “simple interest” always costs less: If unpaid interest is capitalized or payments are deferred, a loan labeled simple interest can still grow unexpectedly.
  • Ignoring payment application rules: Some lenders apply extra payments to future payments rather than principal unless you instruct otherwise.

In-practice insight (from experience)

In my practice advising homeowners and small businesses, I see two recurring themes: borrowers who fixate on nominal rates but ignore compounding, and borrowers who don’t confirm how extra payments are applied. One example: a client refinanced a variable loan into a longer amortized loan without checking compounding and ended up with higher lifetime interest despite a lower advertised rate. Small contract details mattered more than the headline APR.

Frequently asked questions (brief)

  • Which method is cheapest? Short-term simple-interest loans with no capitalized interest are usually cheapest. For long-term borrowing, a lower-rate amortized loan can be better despite large total interest because it provides predictable payments.
  • Does daily compounding double my interest? No—daily compounding raises effective interest slightly versus monthly or annual compounding; it does not multiply the stated rate by the number of days.
  • Can I change the accrual method? Not usually without refinancing or renegotiating; lenders set accrual rules in the contract.

Where to learn more

Professional disclaimer

This article is educational only and does not replace personalized financial, tax, or legal advice. Loan contracts vary; for decisions that affect your finances, consult a qualified financial advisor or tax professional.

Sources: Consumer Financial Protection Bureau; Federal Reserve; IRS guidance on interest and deductions.