What Is Simple Interest And How Is It Calculated?
4-Minute ReadJanuary 21, 2022
If you’ve ever taken out any type of 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, can impact the total amount of money you’ll end up paying on your loan. 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 and how you can calculate it.
Simple Interest Definition
Simple interest is a method used to calculate the interest charged on a loan over a set period of time. Simple interest does not compound, meaning that the interest is calculated on the principal of the loan only and never on the interest that has already accrued. This applies to a variety of loans such as short-term loans, auto loans and some mortgages.
How Does Simple Interest Work?
On a simple interest loan, the lender will apply your monthly payment to the interest first. Then, the remainder of your payment will then go towards reducing your principal.
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. 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.
How To Calculate Simple Interest
Now, let’s take a look at how you can calculate simple interest on your loan. Knowing how to calculate your simple interest can help you better understand how your monthly payment is applied to your loan.
Simple Interest Formula
The formula for calculating simple interest is:
Simple interest = P x R x T
- P = The principal amount, or the initial money you borrowed from the lender.
- R = The interest rate, expressed in decimal form.
- T = The time period of the loan.
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 1-year loan means you’ll need both the annual interest rate and the period of time expressed in years.
Example Of Simple Interest
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:
(5,000) x (.05) x (5) = $1,250
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 the total amount you’d pay for the loan would be:
$5,000 + $1,250 = $6,250
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.
How Simple Interest Rates Affect Borrowers
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.
Simple Interest Vs. Compound Interest
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.
The primary difference between simple and compound interest centers on the variables they use to calculate.
- Simple interest grows based on the principal alone.
- Compound interest uses both the principal and the interest it generates each cycle.
In a compounding interest, you’ll have a larger pile of owed money that is applied to the interest when the loan compounds again. 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.
What Types Of Loans Use Simple Interest?
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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