Introduction
Interest accrual method is one of the single most important but overlooked loan terms. Two loans with the same nominal interest rate can cost very different amounts depending on whether interest is calculated annually, monthly, daily, or whether unpaid interest ever capitalizes (is added to the principal). This guide explains the main accrual methods you’ll see in 2025, gives clear examples, and lists practical strategies you can use to reduce total interest costs.
Background and context
Lenders and regulators have offered a variety of accrual approaches for decades. Historically, “simple interest” was common in many consumer installment loans; modern loan products more often use daily accrual or periodic compounding. Credit cards typically compound interest on unpaid balances, while many mortgages and installment loans calculate interest daily on the outstanding principal and apply payments first to accrued interest (an amortization schedule). Consumer protections and disclosure rules (for example, Truth in Lending Act requirements and CFPB guidance) mean lenders must show how interest is calculated on most consumer loans—so read the disclosure carefully (CFPB: https://www.consumerfinance.gov).
Primary interest accrual methods (what they mean and when you’ll see them)
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Simple (flat) interest
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How it works: Interest is calculated based only on the outstanding principal using I = P × r × t (principal × annual rate × time). If the principal goes down, the interest charge for the next period falls proportionally.
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Where you see it: Many auto loans and some personal installment loans advertise “simple interest”; note that they may still calculate daily interest using the simple-interest formula.
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Daily accrual (simple daily interest)
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How it works: The lender calculates interest each day using the daily rate (annual rate ÷ 365 or ÷ 360). Daily interest = principal × (annual rate / days-in-year). The lender totals daily charges for the billing period. Payments reduce the principal and therefore reduce subsequent daily interest.
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Why it matters: Paying mid-cycle reduces interest immediately because the daily accrual reflects the smaller principal after your payment. Many mortgages and loans use daily accrual; confirm whether the lender uses a 365- or 360-day year because a 360-day (“banker’s year”) slightly increases daily interest.
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Periodic compounding (monthly, quarterly, annually)
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How it works: Interest is calculated at the compounding interval and added to the balance; subsequent interest is charged on principal plus accumulated interest. Formula: A = P(1 + r/n)^{n t} where n = compounding periods per year.
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Where you see it: Savings accounts, some business loans, and certain consumer credit products. Credit cards commonly compound daily or monthly—unpaid interest gets added to the balance and then accrues further interest.
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Capitalization (accrued interest becomes principal)
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How it works: When unpaid interest is added (“capitalized”) to the loan principal (for example, at the end of a deferment or forbearance period on a student loan), future interest accrues on the larger balance.
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Where you see it: Student loan deferments, some mortgages after missed payments, and loans that allow interest to accrue during a forbearance.
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Precomputed interest (Rule of 78s and similar methods)
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How it works: The lender computes total interest over the loan term in advance and applies more of that interest to early payments. The Rule of 78s is a historical method that front-loads interest, making early repayment less favorable.
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Caveats: These methods are less common and are subject to state and federal rules; check your state laws and loan contract. If you’re offered a precomputed loan, ask for the payoff schedule and an early-payoff example.
Examples that show the difference (real numbers)
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Simple daily accrual example
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Loan: $10,000 principal, 5.00% annual rate, daily accrual using 365-day year.
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Daily interest: 10,000 × (0.05 / 365) = $1.37/day. If you pay $1,000 two months in, you reduce future daily interest immediately.
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Compound example
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Loan: $10,000 at 5% compounded annually. After one year: 10,000 × 1.05 = $10,500. After two years: 10,500 × 1.05 = $11,025.
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When compounding matters: If unpaid interest is allowed to capitalize (for example, during a forbearance), you can see compound-like growth on consumer loan balances.
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Credit card example (periodic compounding and daily rates)
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Credit cards often compute a daily periodic rate (APR ÷ 365) and apply it to the average daily balance; unpaid interest compounds as it’s added to the balance. The CFPB explains typical credit card interest calculations and how late payments and fees can increase the effective cost (CFPB: https://www.consumerfinance.gov/consumer-tools/credit-cards/).
Why accrual method changes total cost
- Timing of payments matters more with daily accrual and compound/ capitalization events.
- Compounding or capitalization increases the base on which future interest is charged, so a loan that allows capitalization will generally cost more if unpaid interest is not eliminated quickly.
- Amortizing loans with equal monthly payments often pay mostly interest in early periods; the accrual method determines how much interest is calculated each day or month and therefore how much of each payment reduces principal.
Practical borrower strategies (what to do before and after you sign)
- Read the loan disclosures—look for the exact wording: “interest computed on a daily basis,” “compounded monthly,” “interest shall accrue and be capitalized,” or “precomputed interest.” If the disclosure is ambiguous, ask the lender for a plain-language explanation.
- Ask whether the lender uses a 365- or 360-day year for daily accrual and whether they apply payments to interest first.
- Make early or mid-cycle payments when possible. For daily-accrual loans, paying mid-period reduces the principal immediately and lowers future daily interest.
- Avoid interest capitalization events: if you have student loans and qualify for income-driven plans, ask whether unpaid interest will capitalize at certain stages; try to make interest-only payments during deferment if possible.
- For credit cards, pay the statement balance by the due date to avoid compounding interest and preserve the grace period (see guidance on grace periods and when they apply: FinHelp: “Grace Periods on Loans and Credit Cards” https://finhelp.io/glossary/grace-periods-on-loans-and-credit-cards-how-they-work-and-when-they-apply/).
- Use biweekly or extra principal payments on amortizing loans—those extra dollars go straight toward principal and reduce the interest charged going forward. Consider asking the lender to apply extra payments directly to principal.
- When comparing loans, calculate the effective annual rate based on the accrual method (for example, use the formula for effective annual rate when compounding periods differ). Tools at reputable sites (Investopedia, CFPB) can help with these calculations.
Common borrower mistakes and misconceptions
- Mistaking APR for the actual accrual method: APR includes fees and shows the annual cost, but it doesn’t spell out whether interest compounds daily or monthly—read the contract.
- Assuming every lender uses the same days-in-year—360 vs. 365 makes a measurable difference over large balances.
- Believing “simple interest” always means cheaper: a simple-interest loan with long term and little extra principal reduction can still be costly compared with a shorter compound loan you pay off faster.
- Overlooking capitalization: deferred interest that capitalizes can erase the benefit of a lower headline rate.
Real-world notes from practice
In my practice advising borrowers, the most useful questions I teach clients to ask at origination are: “How exactly is interest calculated?” and “If I make extra payments, how will they be applied?” One borrower avoided thousands in interest by switching from monthly payments to semi-monthly payments on a mortgage that used daily accrual; the mid-cycle payments reduced daily interest accrual and shortened the amortization effectively. Another borrower mistakenly assumed a consolidating lender would not capitalize unpaid interest; confirm capitalization rules in writing before refinancing.
Interlinking resources
- For a deeper dive into how compounding affects loan balances, see FinHelp’s article “How Interest Compounding Affects Your Loan Balance” (internal resource): https://finhelp.io/glossary/how-interest-compounding-affects-your-loan-balance/
- To understand how grace periods interact with interest accrual on cards and some loans, see FinHelp’s “Grace Periods on Loans and Credit Cards: How They Work and When They Apply”: https://finhelp.io/glossary/grace-periods-on-loans-and-credit-cards-how-they-work-and-when-they-apply/
- For general compound-interest explanations and visuals, FinHelp’s “Compound Interest” page is a helpful primer: https://finhelp.io/glossary/compound-interest/
FAQs (short answers)
Q: Which accrual method is cheapest? A: There is no universal “cheapest” method—your payoff timing and whether interest can capitalize determine cost. Daily-accrual loans paid early often cost less than loans that allow capitalization.
Q: Can I change accrual terms after signing? A: Not without refinancing or a formal loan modification. Always confirm terms before you sign.
Q: How can I compare two offers with different accrual methods? A: Convert both offers to an effective annual cost (or run an amortization schedule) using the exact accrual rules the lender discloses.
Sources and further reading
- Consumer Financial Protection Bureau. Credit cards and loan disclosures—how interest is calculated. https://www.consumerfinance.gov (CFPB guidance pages, 2025).
- Investopedia. Compound Interest: what it is and how it works. https://www.investopedia.com
- FinHelp related articles on compounding and grace periods (linked above).
Professional disclaimer
This article is educational and does not constitute financial, legal, or tax advice. Individual circumstances vary—consult a licensed financial advisor or attorney before making decisions about loans or refinancing.
Last reviewed: 2025
