What Is Simple Interest?
Simple interest is an easy and straightforward way to calculate a loan’s interest charge.
Simple interest is calculated by taking the daily interest rate and multiplying it by the principal, multiplied by the number of days between payments.
This sort of interest is typically applied to short-term loans or auto loans, while it is used in some mortgages.
Key Takeaways:
- Simple interest is computed by multiplying the daily interest rate by the principle and then by the number of days between payments.
- Consumers that pay their loans on time or early each month benefit from simple interest.
- Car loans and short-term personal loans are often interest-only loans.
Once you understand how interest works, you can make better-informed financial decisions.
How Simple Interest Works
A basic simple interest definition is the money paid on a loan or money earned on a deposit.
When you borrow money, you must repay not only the amount you borrowed – the principal – but also an extra percentage of the principal, known as interest.
Likewise, if you deposit money into a savings account, you will earn money on the initial deposit, which is also interest.
Unlike compound interest where the amount of interest is calculated based on principal and earned interest, the amount of simple interest you pay or earn is calculated based on the original principal amount.
Tip: When it comes to mastering your finances, it’s important to understand simple interest. While you could use an interest calculator, the math involved is not complex.
Simple Interest Formula
You can use the formula below to calculate simple interest:
I = P x r x t
Calculate simple interest (I) by multiplying the principal (p) by the rate (r) by the number of time periods (t).
As you can see, calculating simple interest is, well… simple. If you prefer, you can always use our simple interest calculator to ensure your numbers are correct.
If you don’t have access to an interest rate calculator you can also use an Excel spreadsheet to assist you with your calculations.
An Example
Consider an automotive loan with a principal balance of $15,000 as well as a simple internet rate of 5% per annum.
Say your first payment is due on June 1 and you pay it on time, the financing firm calculates your interest for the month of May.
In this instance, the interest for 30 days is $61.64.
Nevertheless, if you pay on May 21, the lender will only charge you interest for 20 days in May, reducing your interest payment to $41.09. This is a $20 reduction.
Example: In the above situation, if you sent a $300 payment on June 1, $238.36 would be applied to principal. If you made the same payment on May 20, $258.91 would be applied to principal.
Who Can Benefit from Simple Interest Loans?
As simple interest is usually calculated daily, consumers who pay their loans early or on time every month will benefit the most.
If you pay on time every month, your main balance reduces faster and you pay off the loan sooner than expected.
In contrast, if you pay the loan late, you will pay more interest than if you pay on time.
Simple Interest vs Compound Interest
The cost of borrowing money is referred to as interest, and the lender charges a fee to the borrower for giving the loan. The interest (usually a percentage), can be simple or compounded.
Simple interest is calculated on the loan or deposit’s principal amount.
Compound interest, on the other hand, is calculated using the principal amount and the interest that accrues on it over time.
Because simple interest is calculated just on the principal amount of a loan or deposit, it is simpler to calculate than compound interest.
Compound interest is frequently used in commercial transactions, investments, and financial goods that are designed to last for several months or years.
Simple interest is primarily used for simple computations, such as those for a single period or less than a year, although it also applies to open-ended scenarios, like the balance on a credit card.
Simple Interest FAQs
What is “simple” interest?
The straightforward crediting the cash flow connected to a deposit or investment is referred to as “simple” interest.
Which pays out more over time, compound or simple interest?
After the first payment period, compound interest will always pay more.
What are some examples that make use of simple interest?
The majority of coupon-paying bonds use basic interest. Most personal loans, including auto loans, student loans, home mortgages, fall under this category.
What are some examples that use compound interest instead?
Compound interest is commonly used in credit cards, bank deposit accounts, and various lines of credit.
