Today, lending is a primary interest generating operation in financial institutions such as banks. Interest is the price for the privilege of securing the loan, and it is often expressed as a per annum rate.
Simple Interest
This is a set or a predetermined rate on the principle or the initial amount of money that is given to a debtor that he or she has to pay to the lending institution for them to be able to use the money ( Surbhi, 2015 ). In other terms, simple interest is a fixed-rate earning the bank obtains from an investment, which the loan is given to the borrower. For example, if a debtor has borrowed $200 at a simple interest of 5%, they are expected to pay back $210.
Delegate your assignment to our experts and they will do the rest.
Compound Interest
Unlike simple interest, compound interest is charged on both the principle as well as the compounding interest the borrower has to pay to the bank ( Surbhi, 2015 ). That is, a new principle is computed by adding the interest of a given period to the original principle. The longer the period of borrowing, the higher the interest the borrower will pay back to the lending institution. For instance, if one borrows $200 at a compound interest of 5% per month, he or she will pay the lender $210.23 at the end of the year.
Differences and Similarities of Simple and Compound Interest
Both compound and simple interest earn money to the lender. That is, for the investor (lending institution), their money grows while to the borrower, the cost of borrowing the money increases. Both of these interests usually increase as the repayment time increases.
However, simple interest is computed from the principle the debtor borrows. On the other hand, compound interest is calculated on the original principle plus all the accumulated interest. As such, the principle in simple interest remains constant while it changes in compound interest because of the compounding effect ( Surbhi, 2015 ). In most instances, simple interest applies to short-term loans while compound interest is used on long-term loans. To the investor, a compound interest yields a faster result, which is a disadvantage to the borrower since they have to pay higher interest. On the other side, simple interest has a constant growth.
Ethical issues of Compound and Simple Interests
Interest rates are estimated on an annual percentage rate basis. If this rate is paid annually, no discrepancy will arise between the APR and the effective annual percentage rate ( Bhandari, 1997) . However, if the interests are paid on the monthly or daily basis, the quoted APR differs from the effective annual rate. For example, an individual who borrows $3000 that has 17.99% APR that is compounded on a daily basis will have a total date of $ 3001.48 by the end of the first day. By the end of the first year, the person will have to pay approximately $591.13 interest. When the interest is compounded monthly, the borrower will pay around $586.50. If the interest is compounded on annual basis, the borrower will pay $539.7 in interest. This discrepancy is unethical as it amounts to extortion of money from the borrower. Secondly, the two interests do not consider currency fluctuation ( Bhandari, 1997) . A person who borrows at a loan at a 10% rate and repays the loan in five years might end up paying more money because of this fluctuation. This is worse in compound interest since its growth is exponential as opposed to the constant growth in simple interest. In most cases, the lending institution does not disclose this information to the borrowers with the target of making more money. In addition, most of the lending institutions engage in deceptive advertisement of the interest rates. Many lenders use all means to ensure people borrow finances so that they can make more interest. As such, they promote incorrected advertisement in which they understate the true cost of credit. In other instances, these institutions hide the hidden fees and costs of compound and simple interest loans. Also, the in both compound and simple interest loans, the lenders do not bother to explain to the clients the truth about the financial burdens of either options. For instance, they do not offer the client’s comparative examples of the numerous methods of balance computation, which is a critical element in helping the client, determine which type of loan to take. Thirdly, the loans are given of some securities ( Bhandari, 1997) . For instance, a borrower planning to build a house will be required to provide a guarantee such as the land title deed. In instances where the borrower is not in a position to repay the interest, the lending institution confiscates and auctions their property to recover its investment. Therefore, this will result in a total loss to the borrower, which leaves them in a worse situation than before. Such suffering is unethical since the loans are meant to improve the situation of the borrower. Finally, the clearance of outstanding balances is based on the 78 th rule, which limits the borrower to clear the loan at once. According to the rule, a client will be required to pay all the interest of the remaining term of the contract. That is, if the client wants to pay the loan by cash, renewal or otherwise, the lending institution will require that client to pay the original charge as the sum of the consecutive monthly balances as scheduled in the contract (“ 2006 New Mexico Statutes - Section 58-7-5 — Prepayment; precomputed loan transactions”, 2018 ). This is unethical since it does not give the borrower the freedom to terminate the contract before it expires.
Reference
Bhandari, S. (1997). Journal of Business Ethics, 16(5), 531-535. http://dx.doi.org/10.1023/a:1017993704216
2006 New Mexico Statutes - Section 58-7-5 — Prepayment; precomputed loan transactions. . (2018). Justia Law . Retrieved 24 February 2018, from https://law.justia.com/codes/new-mexico/2006/nmrc/jd_58-7-5-137a5.html
Surbhi, S. (2015). Difference between Simple Interest and Compound Interest (with Example, Formula and Comparison Chart) - Key Differences . Key Differences . Retrieved 24 February 2018, from https://keydifferences.com/difference-between-simple-interest-and-compound-interest.html
