What Is Simple Interest And How Is It Calculated?
If you’ve ever taken out a loan, there’s a good chance that a part of your bill went to interest fees.
Interest, or the money borrowers pay to use a lender’s cash, is a common financial concept that most people already understand. But how exactly is interest calculated, and what is its impact on the total amount of money you’ll end up paying?
Understanding how interest works starts with understanding simple interest. Whether you’re financing a home improvement project or loaning out cash to a friend, simple interest can help you make smarter decisions with your money.
Let’s take a deeper dive into what simple interest is, how you can calculate it and where you’ll find real-world applications for simple interest.
Simple Interest Definition
As its name suggests, simple interest is the simplest method of calculating how much interest will accumulate on borrowed money over a set period of time. Most people use simple interest to determine how much they’ll owe in total over the course of their loan, but you can also calculate simple interest on the money you lend to others or hold in interest-earning accounts.
Simple interest doesn’t consider as many variables as other, more complicated interest formulas, and it’s most commonly applied to short-term loans. Generally speaking, the longer your loan is, the less accurate a simple interest calculation will be.
Understanding simple interest, however, lays a crucial foundation for more complex interest concepts, such as annual percentage rates and fully amortizing payments.
The Simple Interest Formula
Here’s the most common formula for calculating simple interest:
I = Prt
- I equals the amount of interest, or the simple interest that is accumulated on the loan.
- P equals the principal amount, or the initial money you borrowed from the lender.
- r equals the interest rate, expressed in decimal form.
- t equals the time period of the loan.
In other words, simple interest = (principal) X (interest rate) X (time period).
Note that your interest rate and time period must be in the same unit of time (such as years, months or days). For instance, calculating interest on a one-year loan means you’ll need both the annual interest rate and the period of time expressed in years.
How To Calculate Simple Interest (An Example)
Let’s see how these variables work together in a hypothetical situation. Suppose you’ve agreed to borrow $5,000 at an annual interest rate of 5%.
To find the simple interest over a 5-year repayment period, you would multiply the principal amount (5,000) by the decimal interest rate (.05) and the length of time (5), which would equal $1,250 in interest payments. From there, calculating the total amount you’ll pay for the loan is as easy as adding the principal and interest together. In this example, you’d pay $6,250 overall.
You can also use the simple interest formula to figure out how much you’ll end up saving by paying off the debt quickly. Let’s use the same example loan figures and assume you’re able to completely repay the loan after 1 year. The resulting formula (5,000 X .05 X 1) will equal a much lower total interest of $250.
Breaking Down Simple Interest Rates
As shown in the previous example, loans that use simple interest rates are an advantage for borrowers who are able to pay back their loans early. This is because the money borrowers put toward simple interest loans pays off the interest first and principal second.
On the other hand, those who are late to pay their bills will give that interest more time to accumulate, meaning a smaller share of your repayment will go toward tackling the principal balance.
Calculating simple interest is somewhat impractical on loan types that incorporate values beyond the principal to determine what your monthly bill will look like. To have a better handle on these loans, you’ll first need to understand the difference between simple and compounding interest.
Simple Interest Vs. Compound Interest
In the most basic terms, compounding interest is the interest that accrues on top of existing interest. This amount is added to your principal balance, meaning that you’ll have a larger pile of owed money that is applied to the interest when the loan compounds again.
The primary difference between simple and compound interest centers on the variables they use to calculate. Where simple interest grows based on the principal alone, compound interest uses both the principal and the interest it generates each cycle.
Compound interest loans rely on what’s known as the compounding frequency to determine the rate at which interest is combined with your principal. Some debts may compound monthly, while others could have a daily compounding frequency.
The shorter the time span, the more your interest will compound. That’s why earning compound interest on investments offers substantial growth opportunities, but paying it off (especially when it comes to credit card debt) becomes more challenging with time.
Types Of Simple Interest Loans
Simple interest loans aren’t the most common option on the market, but that doesn’t mean you won’t ever encounter them. Because they are repaid in a short timeframe, some personal loans and auto loans use simple interest. In rare circumstances, mortgages are offered with simple interest, especially if the borrower has opted for bi-weekly payments or agreed to a daily interest rate.
Similar to applying for other loan types, improving your credit score can boost your chances of securing a simple interest loan.
Most people will take on at least one type of loan at some point in their lives, and simple interest provides a valuable first step toward recognizing the role interest plays. Understanding your interest means you’ll be equipped to target your debt strategically and make the most of your repayment plan - helping you achieve more and save you money in the end.
Ready to learn more about the world of personal finances? Check out our other financial resources for help managing interest rates, credit scores and more.
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