What Is Simple Interest?
Simple interest is a quick and straightforward way to calculate a loan’s interest charge. Simple interest is calculated by multiplying the daily interest rate by the principal, multiplied by the number of days between payments.
This sort of interest is typically applied to auto loans or short-term loans, while it is used in some mortgages.
- 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.
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.
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.
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.
Another option would be to use an Excel spreadsheet to assist you with your calculations.
Consider an automotive loan with a $15,000 principal balance and an annual 5% simple interest rate to better understand how simple interest works.
If your payment is due on May 1 and you pay it on time, the financing firm calculates your interest for the month of April.
In this instance, your interest for 30 days is $61.64.
Nevertheless, if you pay on April 21, the credit firm will only charge you interest for 20 days in April, reducing your interest payment to $41.09, a $20 reduction.
Who Can Benefit from Simple Interest Loans?
Because simple interest is frequently calculated on a daily basis, consumers who pay their loans on time or early each month gain the most.
Example: In the above situation, if you sent a $300 payment on May 1, $238.36 would be applied to principal. If you made the same payment on April 20, $258.91 would be applied to principal.
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 borrower pays a fee to the lender in exchange for the loan.
The interest, which is usually stated as a percentage, might 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.
In real life, compound interest is frequently a role 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, such as credit card balances.
Simple Interest FAQs
What is “simple” interest?
The straightforward crediting of cash flows connected with some investment or deposit 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 of financial instruments that make use of simple interest?
The majority of coupon-paying bonds use basic interest. Most personal loans, including school loans, auto loans, and home mortgages, fall under this category.
What are some examples of financial instruments that use compound interest instead?
Compound interest is commonly used in bank deposit accounts, credit cards, and various lines of credit.