## Can Banks Charge Interest on Interest for Loans or Just the Principal?

written by: Steve McFarlane•edited by: Jean Scheid•updated: 6/14/2011

Here, we will look at the popular methods of calculating the interest charge on loans and also answer the question: Can banks charge interest on interest for loans or is it just charged on the principal?

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Interest is the portion of a loan that is paid as a fee for borrowing the loaned amount. In essence, interest is a rent, of sorts, but interest is usually charged as a way to offset the credit risk (risk of losing the principal) and as compensation for the opportunity cost (the lost opportunity of investing in something else).

However, lenders don’t just charge interest to offset credit risk and opportunity cost, they also charge an interest to cover expenses that includes salaries, utilities, and operating expenses. Lenders also earn from the transaction fees they charge to process the loan, in addition to the interest that borrowers pay.

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### Ways of Calculating Interest Payments on Bank Loans

It is important that consumers know how their lending institution calculates the interest on outstanding loans, because it can account for a substantial difference in the amount that will have to be repaid. In general, there are two methods that are used to calculate interest; these are the add-on and the reducing balance methods.

Add-On – Using this method, the payable interest is calculated when the loan is issued, so the borrowers knows how much will need to be paid in addition to the principal. Because the total interest is fixed at the beginning of the loan, the borrower has less incentive to repay the loan before it is mature. This is because he doesn’t stand to save anything by paying off the loan early, as is the case with a loan calculated using the reducing balance method.

Reducing Balance – This method calculates interest based on the current account balance/loan balance instead of the original loan amount. Assuming that regular payments are being made (interest and a portion of the principal), after each payment, the total that is outstanding will become less, and so will the next interest payment that becomes due since it is calculated on a lower balance. This is why a reducing balance loan is a better option if the borrower fancies the option of paying off the loan ahead of time.

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### Can They Get Away With It?

If the interest and principal are not paid by the agreed times, the bank may add the interest incurred from the previous period to the loan balance (depending on the terms of the loan). Therefore, the next payment will include the regular interest, plus an interest charge on the interest that had become past due.

Charging interest on interest is known as compounding and it is exactly how banks compute interest to be paid to their clients for money held in savings accounts. Therefore, banks have no qualms about charging their customers compounding interest on outstanding loan portfolios.

To answer the question, can banks charge interest on interest for loans? The answer is yes.

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