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If you invest $100,000 at 10% simple interest, the interest that would be paid over a one year period would be $10,000.  That would be a $833.33 monthly payment or a one time annual payment of $10,000.  At the end of year one you would have earned $10,000 and have received over the year the total of $110,000, with your principle being re-paid.

If the interest is pre-paid, then the $10,000 interest payments, are given back to the Lender at the start, instead of the Lender waiting for them.  Instead of the Lender paying $100,000 and receiving $10,000 back immediately, the Borrower has the lender only pay $90,000.  This way at the end of year one, they receive the $100,000 back plus they have the $10,000 in their pocket already.  Equalling the same $110,000 return.

One reason is, the Borrower has already accounted for and paid the interest for year one.  This lowers the payout obligation in the end.  A second reason is, the borrower then doesn’t have monthly payments to worry about paying on a regular basis, which can lessen the administrative burden of making interest payments to every lender throughout the year.

The Lender now has the option to do whatever they want with the $10,000 interest payment they received up front.  They can even re-invest it and earn more interest!

In the scenario above, the Lender is only investing $90,000 of real cash, even though the Lending Agreement shows a $100,000 lend.  Investing $90,000 and receiving $100,000 back at the end of the term is actually higher than 10% return!  10% of $90,000 is $9,000, but the Lender is receiving $10,000.  This gives an effective rate of return of 11.1%!