What is simple interest and how is it calculated?

Simple interest’s meaning is handy to know, and, like the name indicates, fairly simple to grasp. It essentially describes the interest charges that you’ll pay as a borrower to a lender in exchange for receiving a loan.

In effect, simple interest describes how much it costs to receive access to any funds lent and impacts how much that you’ll pay in service fees in total for borrowing any such sums.

If you’ve ever taken out any type of loan, you’ll likely be familiar with the concept… and aware that it is calculated based on principal alone, rather than compounding interest.

Understanding how associated charges work can help you get a better handle on total expenses associated with borrowing money, and make smarter financial decisions.

No matter if you’re considering how to finance a new car or home improvement project, or are considering lending money to a friend, let’s take a closer look at simple interest’s meaning and how to calculate it.

What is the simple interest definition?

If you’ve ever received a loan, you’ll be aware that the total cost that you’ll pay over time to enjoy access to these sums exceeds the actual amount of money that you have borrowed (aka the loan principal). That’s because a portion of the costs that you’ll render to the lender each month goes towards paying off interest charges – effectively what a lender charges you to service the loan.

Simple interest’s meaning describes a method that’s used to calculate the interest charges that you’ll encounter on a loan over a predetermined amount of time. Happily for borrowers, it does not compound. That means that simple interest charges are calculated based solely on the principal of the loan, and not based on an amount that factors in additional interest charges that accrue and compound over time. In other words, you’ll pay interest only on the funds that you’ve borrowed, as opposed to an amount that increases with each passing billing cycle.

Simple interest loans are typically used for purposes of issuing short-term loans (e.g. personal and auto loans), and used for borrowers who agree to take on certain mortgages with fixed timelines and payment terms.

How does simple interest work?

Simple interest offers a quick and easy way to calculate any associated interest charges that may appear on a loan. It doesn’t take into account anywhere near as many financial variables as other, more complicated interest formulas, making it a preferred option for borrowers where possible.

In essence, if you elect to take out a simple interest loan, lenders will apply your monthly payments towards paying off interest charges first. Afterwards, the remainder of the payment will be put towards reducing your loan principal. Understanding simple interest calculations can help you get a better understanding of how loans and lenders work. It can also help you get a better handle on more complex concepts including annual percentage rates, compound interest loans, and fully amortizing payments as well.

Note that most individuals tend to use simple interest calculations to determine how much that they’ll owe in total over the full lifetime of a loan. However, if you’d like, you can also use the formula to crunch the numbers and determine what you’ll earn in simple interest on any money lent to others, or that you hold in interest-earning accounts.

How to calculate simple interest

Understanding how and when to apply the calculation provides a better sense of how much that you’ll pay in interest charges over time, and how lender servicing fees affect your total loan costs.

Knowing how to calculate simple interest also provides a clearer picture of how specific portions of your monthly payments are applied to different balances, helping you make more informed financial decisions.

Simple interest formula

Simple interest is determined by multiplying the daily interest rate on the loan by the loan principal and then by the total number of days that will elapse between payments.

In essence, the formula for calculating simple interest charges is expressed as: P x R x T

Where:

• P = The principal amount (how much money that you have borrowed from a lender).
• R = The interest rate, expressed in decimal form.
• T = The time period of the loan.

Keep in mind that for standardization and clarity’s sake, your interest rate and time period must be expressed in the same period of time. (for example, d ays, months, or years.)

For example, if you plan to calculate simple interest charges on a 1-year loan, it requires you to know both your annual interest rate and to express the time period in a 1-year block.

Example of simple interest

For clarity’s sake, let’s take a closer look at how the numbers break down in a hypothetical scenario.

Say, for instance, that you have elected to borrow $10,000 at an annual interest rate of 12%.

To calculate the simple interest that you’ll pay over a 5-year repayment period, you would simply run the numbers as follows:

$10,000 x .12 x 5 = $6000 – in other words, you’d pay $6000 in interest charges.

Afterwards, calculating the total amount that you can expect to pay overall for the loan over its lifetime is as simple as adding the amount that you owe in principal and the interest charges together.

Keeping with the above example, your total cost for the loan would be: $10,000 + $6,000 = $16,000.

Budget-minded savers will note that you can also utilize the simple interest formula as a way to quickly determine how much that you can save by paying of the debt quickly.

By way of illustration, let’s use the same figures as above, but assume that you completely pay off the loan within 1 year. Based on the calculations ($10,000 x .12 x 1) you can see that total interest charges are just $1,200 – a savings of roughly $4,800.

How simple interest rates affect borrowers

As you can see from the previous example, simple interest’s meaning isn’t hard to determine – and loans that use simple interest rates present significant advantages for borrowers with the ability to repay loans early.

On the flip side, that also means that folks who are late in terms of paying their bills potentially give that selfsame interest more time to accumulate. Under these circumstances, a smaller share of your repayment would be applied toward paying down the principal balance.

Simple interest vs. compound interest

Note that calculating simple interest isn’t a preferred method of computation for loan types that use values besides your loan principal to determine what your monthly bill will be, however.

To more accurately compute costs relating to these loans, you’ll first need to understand the difference between how compound and simple interest works.

The main difference between both types of interest lies in the variables that both use to compute related expenses. It may help to note that:

• Simple interest is based on loan principal alone
• Compound interest applies to both the principal and the interest it generates each cycle, effectively growing costs by a multiplying factor with each passing cycle

Under compounding interest scenarios, you’ll effectively owe more money that is applied to interest charges each time that the loan compounds. Note that some debts may be scheduled to compound monthly, while others could compound on a more regular basis, like daily.

As a general rule of thumb, the shorter that the time span of the loan is, the more that your interest will compound. That’s why earning compound interest on investments offers substantial growth opportunities for investors. However, as you can see, the downside of compounding interest is that paying it off (especially when it comes to credit card debt) can become more challenging over time.

What type of loans use simple interest?

Numerous variables influence whether a loan uses simple or compound interest, e.g. the type of loan, individual lender policy and a prospective borrower’s financial needs and goals.

For instance, simple interest typically applies to installment-based loan products such as personal, auto, mortgage, and student loans. It’s common to see it utilized with financial products that boast fixed loan terms and amortization schedules, providing borrowers with more predictable costs and easier expenses to compute. Armed with a cost schedule, you should be able to plan your regular monthly budget around these charges.

Compound interest is more common to see associated with forms of revolving debt such as credit cards. It causes interest to accumulate on both the unpaid balance itself as well as any prior interest charges that you have accrued. Making a point to regularly pay your bills on time and (if you can afford to do so) put additional funds toward your bills with each installment to help pay down balances more rapidly can help you prevent charges from piling up here.

Note that in many cases improving your credit score can boost your chances of securing a simple interest loan.

The bottom line: The benefits of a simple interest loan

A simple interest loan is typically far more affordable over time than one based on compounding interest rates. That’s because interest charges applied by lenders are calculated based on your loan principal (the amount of money borrowed) alone vs. compounding interest charges on top of the principal that pile up over time. This also means that simple interest loans are typically easier for prospective borrowers to pay off, especially over an extended time period, provided that you pay your bills on time.

Understanding simple interest’s meaning isn’t hard, and helps provide a useful first step towards understanding how interest works in general. Being aware of the concept not only makes it easier to assess potential loan terms and options, and understand how much money that you might earn on any funds that you choose to lend to other individuals. It also helps you more strategically target debt and make the most of any given loan repayment plan – helping you save money and stretch your budget further in the end.

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!