What is simple interest and how is it calculated?

As its name suggests, simple interest is easy to understand. It’s a way to determine how much you will pay a lender in addition to the amount you borrow. Knowing how simple interest works will help you better understand the cost of borrowing money.

Defining simple interest

If you’ve taken out any type of loan, you know that the amount you borrow is called the principal. The additional amount you pay is the interest.

Simple interest is expressed as a percentage and applies only to the principal. Simple interest is usually used for short-term loans, such as personal and auto loans. It also is used for mortgages with fixed timelines and payment terms.

How does simple interest work?

Simple interest lets you calculate how much interest you’ll pay on a loan using the amount borrowed, the interest rate, and the loan term.

Simple interest loans can allocate each payment toward principal and interest in different ways. The simplest is to calculate the interest amount, add it to the principal, and divide it by the number of payments. With the final payment, you’ll retire the debt.

Amortization is a method where interest is paid on the principal balance, which adjusts with each payment. When you start paying the loan, most of your payment is applied to interest and a small portion to the balance. The balance will be reduced with each payment, meaning you pay less interest each month and more toward the balance. This continues until the final payment, which will be almost all balance and a small amount of interest.

How to calculate simple interest

Simple interest is determined by multiplying the loan principal by the interest rate and the loan term.

As a formula, it looks like this:

Total interest paid = Principal amount x Interest rate x Loan term

Simple interest example

Say you borrow $10,000 at an annual interest rate of 12% and plan to repay it over five years. You’d plug those numbers into the formula this way:

$10,000 x 0.12 x 5 = $6,000

That means you’d pay $6,000 in interest, plus the $10,000 principal for a total repayment of $16,000. The monthly payment on that loan would be $266.67.

You can save money by getting a lower interest rate or paying your debt more quickly.

If you got the same loan at 9%, you’d pay $4,500 in interest over five years. The monthly payment would be $241.67.

If you paid off the original loan in three years instead of five, you’d pay $3,600 in interest at 12%. The monthly payment would be $377.78.

Simple interest vs. compound interest

The alternative to simple interest is compound interest. The main difference between simple and compound interest is how the interest is applied:

• Simple interest applies only to the loan principal.
• Compound interest applies to the principal and any unpaid interest, which can quickly multiply the amount owed.

Compound interest often is used on credit cards. If you make a payment that doesn’t cover all the interest applied to your balance that month, the unpaid interest is added to your balance. Your next bill will use that higher balance to calculate your next payment.

Note that some debts compound monthly, while others compound daily. The more frequently interest compounds, the faster it grows.

Earning compound interest on an investment offers substantial rewards for investors, as you’ll earn interest on the interest you’ve earned. However, repaying a loan with compound interest, such as credit card debt, can become challenging.

What types of loans use simple interest?

Simple interest typically applies to installment-based loans, such as personal, auto, and student loans. Mortgages also use simple interest but are usually amortized.

Compound interest is more common with revolving debt, primarily credit cards. Interest accumulates on the unpaid balance and any prior interest charges that have accrued. Paying your bills on time and – if you can afford it – paying more than the minimum to reduce your balance will help prevent charges from piling up.

Improving your credit score can boost your chances of securing a simple interest loan.

The bottom line: Benefits of simple interest

A simple interest loan is typically more affordable than one with compound interest. That’s because your interest charges are calculated based only on the principal. This also means that simple interest loans are relatively easy to pay off, especially over an extended period.

Interested in learning more about loans and other forms of interest? Be sure to check out our ever-growing library of financial resources for help managing interest rates, securing a loan, and more.