Compounding or Simple Interest: How Interest Rates on Life Insurance Loans are Calculated

Interest is a complex topic that only gets more complex as you dig down into it. As such, interest rates are often misunderstood. One example is the common misconception about how rates of return work, which we previously covered. Another misconception is about the difference between principal and interest on a mortgage, which we'll cover soon. Today, though, we're talking about how interest rates on life insurance loans are calculated, and why they're not simple interest loans.

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How interest rates on life insurance loans are calculated. Compounding or simple interest

What's the Difference Between Compounding or Simple Interest?

Investopedia explains Compound Interest as “the interest on savings calculated on both the initial principal and the accumulated interest from previous periods.” Investopedia explains Simple Interest by saying, “Simple interest is based on the original principal amount of a loan or deposit.

While many people can wrap their heads around the idea of compounding interest on their savings, people also erroneously believe that loans are the opposite. After all, if you have a declining balance, how can the interest possibly be compounding?

The answer is that those loans compound between payments, and your payments are designed to decrease your balance based on pre-calculated compounding.

For example, if your payment frequency is less than your compounding frequency, compound interest occurs between payments. So if you pay monthly, but your financial institution (bank or insurance company) computes interest daily, as most do, then compounding occurs between your monthly payments every single day.

Most bank loans charge compound interest because the interest frequency is daily. Meanwhile, payment frequency is monthly, therefore there is interest charged on interest daily as it accrues throughout the month. Then the monthly payment wipes out the accrued interest and some principal, and the process starts again. This is by design.

Are Interest Rates on Life Insurance Loans Compound or Simple?

In the same fashion, a life insurance loan is most often compounded daily and the payments are made either monthly or annually, so it too is a “compound interest loan.” However, many people erroneously consider it to be simple interest.

For example, if a company's APR is 5.5%, then the daily rate (because they compound daily, like most banks) is 0.014669% (or 0.00014669). If you multiply 0.00014669 by the days in a year (365), it equals 0.05354185 or 5.35%.   

So why is the sum of the daily rates (5.35%) less than the stated annual rate of 5.5%? The answer is that 5.5% is the actual APR (just like at a bank), and takes into account the daily compounding that has occurred. So what looks and feels like simple interest is actually compound interest.

By the same token, many people discuss credit card monthly credit card charges as if the monthly charge can simply be added up to make the sum of the annual interest (like 1% a month is equal to 12% a year, or 1.5% a month is equal to 18%). Yet in reality, those monthly charges do compound, and 1.5% is actually 19.56% in practice; it's not just 18%.

To say a loan with a life insurance company is simple interest and not compound interest is entirely false. If it were true, you wouldn't get credit back (at interest) for making loan payments in advance vs. in arrears.

Want the Whole Truth?

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