Simple interest is a loan interest payment that borrowers pay to lenders. It is based solely on the principal and does not account for compounding interest. Simple interest is not limited to certain loans. It is also the form of interest that banks pay on savings accounts.
The formula for calculating simple interest is straightforward. Simply multiply the loan’s principle amount by the annual interest rate multiplied by the loan’s length in years.
This sort of interest is typically applied to auto loans or short-term loans, while it is used in some mortgages.
How Simple Interest Works
The expense of borrowing money is expressed as interest. It is typically represented as a percentage and amounts to a fee or charge that the borrower pays to the lender in exchange for the borrowed amount.
Simple interest is a straightforward technique to calculate the cost of borrowing. The interest rate is computed against the principal amount, which never changes as long as payments are made on time. There is no compounding interest or interest rate computation against an increasing total balance.
That is, if the loan duration is more than one year, you will always pay less interest with a simple interest loan than with a compound interest loan.
Many loan agreements entail a more complicated interest calculation than basic interest.
The Advantages of a Simple Interest Loan
- Interest is not compounded or added to the principal amount, resulting in a higher borrowing cost. There is no such thing as compound interest.
- Borrowers may be able to save money.
- Debts may be easier to repay.
- The simple interest calculation is easy to understand.
- Borrowers benefit from simple interest because it does not account for compound interest. Compound interest, on the other hand, is critical to the accumulation of wealth for investors.
How to Calculate Simple Interest
Simply multiply the principal amount by the interest rate and the time to calculate simple interest. The written formula is “Simple Interest = Principal x Interest Rate x Time.”
This is the simplest technique to calculate interest. Once you’ve mastered simple interest, you can go on to more complex formulas like annual percentage yield (APY), annual percentage rate (APR), and compound interest.
Simple Interest Example
As a reminder, simple interest is a fixed percentage of the principal amount borrowed or lent over a given term.
Assume a student obtains a simple interest loan to pay for one year of college tuition. The loan is for $18,000.00. The loan has an annual interest rate of 6%. In addition, the loan has a three-year term.
Using the preceding simple interest method, the simple interest on the student loan is: $18,0000.063=$3,240
As a result, the total principal and interest paid to the lender is: $18,000+$3,240=$21,240.
Daily Simple Interest vs. Simple Interest
Simple Interest is comparable to Daily Simple Interest, except that interest accrues daily and is applied to your account balance with the latter. Furthermore, although simple interest loan balances are lowered on the payment due date, daily simple interest loan balances are reduced on the day payments are received.
What Loans Make Use of Simple Interest?
Simple interest is typically applied to car loans or short-term personal loans. In the United States, most mortgages with an amortization plan also include simple interest, albeit they often feel like compound interest loans.
The compounding effect is caused by variable principal payments, which are the percentage of your mortgage payment that goes toward the loan itself rather than the interest.
The interest does not accumulate. Rather, it is the principal payments that do so. A $1,000 principal payment saves interest on that $1,000, resulting in bigger principal payments the following year, and so on.
The loan interest does not compound if the principal payments are not allowed to vary, as in an interest-only loan (zero principal payment), or if the principal installments are equalized. If you make partial payments on a simple interest loan, the interest portion is deducted first, and the remaining amount is applied to the principle.
Reduced interest rates, shorter loan terms, and principal prepayment all have a compounding effect.
Consider biweekly mortgage payment plans. Biweekly payment plans often assist consumers in paying off their mortgages earlier since borrowers make two more payments per year, saving interest throughout the life of the loan by paying off the principal sooner.
A personal loan calculator can be a wonderful tool to calculate an interest rate that is within your means for a short-term personal loan. This calculator may also be useful for longer-term loans.
Simple Interest vs. Compound Interest
Simple interest is calculated on the principal balance only once a year. So, a $1,000 loan or investment with a 5% annual percentage rate (APR) would accrue $50 in interest after a year.
Compound interest is far more complicated and diverse. It is applied to both the principal balance and any accumulated interest. The compound interest rate is also routinely calculated (daily, monthly, and quarterly).
The calculation of simple interest versus compound interest relies on different financial information. Here’s how these two types of interests differ:
Simple Interest
- Annual compound interest is charged on the principle. The interest is then calculated and added to the principal balance.
- Charge on both the principal and the interest
- Always computed on an annual basis
- Calculated at various intervals, such as daily, monthly, quarterly, or annually
- Depending on the institution, interest rates can be fixed.
- Interest rates may vary depending on the type of account.
How Simple Interest Works
Simple interest lives up to its name; it’s a straightforward method of calculating interest that uses the principal balance and ignores any interest that has already accrued annually. For example, the simple interest on a $30,000 auto loan with an annual interest rate of 2.25% over a four-year term is $2,700. Here’s the fundamental simple interest calculation to help you understand how that number is calculated:
Simple Interest Calculator
The following is the formula for computing simple interest:
I = Prt
I = accumulated interest
P denotes the initial main balance.
r denotes the interest rate.
t = the number of time periods that have passed (in years)
Let’s look at the previous example again:
P = $30,000 (car loan).
r =.0225 (the interest rate in decimal form is 2.25%).
t = 4 (years in years)
I = 30000*.0225*4
To calculate the interest, multiply the principal of $30,000 by the interest rate (2.25%) and the amount of time periods elapsed (4 years). This totals $2,700, which is the interest you’d pay on top of what you borrowed. That means the total amount you could anticipate to pay over 48 months would be $32,700 (principal plus interest).
Compound Interest
Because of how (and what) the computation incorporates, compound interest can produce substantially higher totals than simple interest. When you compute compound interest, you take into account both the principal balance and any previously accrued interest.
This might make lending an expensive proposition: for example, if your credit card compounded interest daily, you’d be paying the previous day’s interest on top of the existing main debt, implying that your financial obligations would swiftly expand.
Compound interest, on the other hand, can work in your favor. For example, if you invest in a retirement plan early and consistently, you will profit from compounding interest over time. If your assets earn compound interest over time, your future interest payments are calculated using both your existing principal and what you’ve already earned through prior interest payments. The earlier you begin saving, the longer your investment has to grow.
As an example, suppose you invest $10,000 at a 3.875% annual rate of return. Compounded interest would provide $394.45 over the course of a year, for a total of $10,394.46. Here’s how to compute compound interest:
Compound Interest Calculator
Compound interest is calculated using the following formula:
ButA = P(1+r/n)nt A = total amount
P denotes the initial main balance.
r denotes the interest rate.
n = the number of times interest has been applied per time period.
t = the number of time periods that have passed (in months or years).
Applying this formula to the previous example of 3.875% interest compounded monthly on a $10,000 balance:
P = ten thousand dollars (deposit amount)
r =.03875 (the decimal equivalent of the 3.875% interest rate)
n = 12 (number of months in the time period)
t = 1 (time elapsed — in years)
Plugging the above data into the formula yields:
A = 10,000.00(1 + 0.03875/12)(12)(1)
The parenthesis appear first.
A = 10,000.00(1.003229167)12
The exponents and multiplication follow next, leaving the account owner with:
A = $10,394.46
Invest $10,000 at a 3.875% yearly rate of return. Monthly compounding over a year would result in $394.46, for a total of $10,394.46.
This minor distinction can make a substantial difference in the amount of money you earn (or owe) in interest.
Simple vs. Compound Interest in Practice
The type of interest you might receive as part of a loan or investment depends on the product. Simple interest is used in installment loans, as it is in auto loans and mortgages. This means you’ll pay less interest as your debt decreases.
Compounding interest is commonly used in savings accounts and credit cards. Thus, you’ll be paying more interest as the debt matures. This is beneficial in the case of savings accounts, but not so much in the case of credit card or student loan debt; the less you pay off on your original loan balance, the more the total amount (principal plus interest) owed accumulates due to interest.
Assume you had a $5,000 loan with an interest rate of 15.16%. In this case, we’ll keep the APR constant.
| Principal | APR | Total Principal and Interest Balance, 1 yr. (simple) | Total Principal and Interest Balance, 5 yr. (simple) | Total Principal and Interest Balance, 1 yr. (compound, monthly) | Total Principal and Interest Balance, 5 yr. (compound, monthly) |
| $5,000 | 15.16% | $5,758.00 | $8,790.00 | $5,812.00 | $10,619.48 |
When you examine how compounding impacts interest payments, the distinction between simple and compound interest becomes clear. That is why it is critical to assess the best funding option for you, as well as how your investments create interest over time.
Simple Interest’s Limitations
The simple interest computation provides a fundamental understanding of interest. It’s a general introduction to the idea of interest. In the actual world, whether you’re paying or earning interest, it’s frequently computed using more complicated procedures.
A loan may potentially include other charges in addition to interest. These fees will affect the overall amount you pay on the loan over the course of the year, but they may not be included in the interest rate provided by the lender.
Why Is Simple Interest Simple?
The crediting of cash flows connected with an investment or deposit is referred to as “simple” interest. For example, a 1% annual simple interest rate would credit $1 for every $100 invested each year. Simple interest, on the other hand, takes not account for the power of compounding, or interest-on-interest, where the 1% would actually be generated on the $101 sum after the first year—adding up to $1.01. The 1% would be earned on $102.01 the next year, for a total of $1.02. And so forth.
Which Will Pay Out More Over Time, Simple or Compound Interest?
After the first payment period, compound interest always pays more. Assume you borrow $10,000 at a 10% annual interest rate, with the principal and interest due in three years as a lump payment. Using a straightforward interest computation, 10% of the principal sum is added to your payback amount over the course of three years. That works out to $1,000 per year in interest, for a total of $3,000 in interest over the life of the loan.
The repayment amount is then $13,000. Assume you obtain the same loan with the same terms, but the interest is compounded annually. When the debt matures, instead of owing $13,000, you will owe $13,310. While $310 may not seem like a significant difference, keep in mind that this is simply a three-year loan; compound interest accumulates and becomes oppressive with longer loan terms.
What Are Some Financial Instruments That Use 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 Financial Instruments That Use Compound Interest?
Compound interest is commonly used in bank deposit accounts, credit cards, and various lines of credit.
In Conclusion,
Simple interest is the interest charge on a loan calculated using only the original principal amount and a fixed interest rate. It does not use compounding, which causes borrowers to pay interest on principal and interest that accumulates over numerous payment periods.
Because of its cheaper cost of money, simple interest might be advantageous for borrowers. However, keep in mind that, due to its simplicity, it only provides a basic notion of cost and may not account for extra charges/fees that a loan may have.
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