What Is Simple Interest?

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What Is Simple Interest?

Let me explain simple interest directly to you: it's the interest charge that borrowers pay to lenders for a loan, calculated only on the principal without any compounding. You'll see this not just in loans but also in the interest banks pay on savings accounts. The formula is straightforward—multiply the principal by the annual interest rate and then by the loan term in years. This method typically applies to auto loans or short-term loans, though some mortgages use it too.

Key Takeaways

Simple interest is calculated by multiplying loan principal by the interest rate and then by the term of a loan.
Simple interest can provide borrowers with a basic idea of a borrowing cost.
Auto loans and short-term personal loans are usually simple interest loans.
Simple interest involves no calculation of compound interest.
A benefit of simple interest over compound interest can be a lower borrowing cost.

Understanding Simple Interest

Interest is simply the cost of borrowing money, expressed as a percentage fee that you pay the lender for the amount financed. Simple interest gives you an easy way to figure out the charge for borrowing. It's calculated against the principal, and that amount stays the same as long as you make timely payments. There's no compounding or interest added to a growing balance. That means, for loans longer than a year, you'll pay less with simple interest than with compound interest. Keep in mind, many debts use more complex interest calculations.

Benefits of a Simple Interest Loan

With simple interest, interest doesn't compound or add to the principal, so you avoid paying interest on interest. This lets you save money as a borrower, and debts become easier to pay off. The calculation itself is simple and straightforward. Remember, simple interest is better for you as a borrower since it ignores compound interest, while compound interest helps investors build wealth.

Simple Interest Formula

The formula for simple interest is direct: Simple Interest = P × r × n, where P is the principal, r is the interest rate, and n is the term of the loan in years.

Example of Simple Interest

Simple interest paid or received is a fixed percentage of the principal borrowed or lent over a period. For instance, if a student takes a $18,000 simple interest loan at 6% annual rate for three years to cover college tuition, the interest is $18,000 × 0.06 × 3 = $3,240. So, the total repayment is $18,000 + $3,240 = $21,240.

Simple Interest vs. Daily Simple Interest

Simple interest is like daily simple interest, but the latter accrues daily and adds to your balance. With simple interest, balances reduce on the payment due date, while daily simple interest reduces them on the day payments arrive.

What Types of Loans Use Simple Interest?

Simple interest often applies to auto loans or short-term personal loans. In the U.S., most mortgages on amortization schedules use simple interest too, though they might feel like compound interest due to varying principal payments. The interest itself doesn't compound; principal payments do. If you make partial payments, they apply to interest first, then principal. Lowering the rate, shortening the term, or prepaying principal creates a compounding effect. Bi-weekly mortgage plans, for example, help pay off loans early by adding extra payments yearly, saving interest by reducing principal faster. For short-term loans, use a personal loan calculator to check rates; it helps for longer terms too.

Simple Interest vs. Compound Interest

Interest can be simple or compounded. Simple interest uses the original principal. Compound interest adds interest to the principal each period, growing payments over time, especially with frequent compounding. Simple interest is easier to calculate. It's used for short loans, while compound interest suits investments or multi-year products. The compound interest formula is P × (1 + r)^n - P.

Borrowing Cost With Simple Interest

Suppose you borrow $10,000 at 5% simple interest for five years for a car. Interest is $10,000 × 0.05 × 5 = $2,500, so total repayment is $12,500.

Borrowing Cost With Compound Interest

For the same loan with compound interest, interest is $10,000 × (1 + 0.05)^5 - $10,000 = $2,762.82, making total $12,762.82.

Why Is Simple Interest 'Simple'?

'Simple' means straightforward crediting of cash flows. For 1% annual simple interest on $100, you get $1 yearly without compounding. Compounding would earn on the growing balance.

Which Will Pay Out More Over Time, Simple or Compound Interest?

Compound interest pays more after the first period. For $10,000 at 10% over three years, simple interest totals $3,000 in interest ($13,000 due). Compounded annually, it's $3,310 ($13,310 due). It grows more with longer terms.

What Are Some Financial Instruments That Use Simple Interest?

Coupon-paying bonds, personal loans like student and auto loans, and home mortgages use simple interest.

What Are Some Financial Instruments That Use Compound Interest?

Bank deposits, credit cards, and some lines of credit use compound interest.

The Bottom Line

Simple interest is calculated on the original principal with a fixed rate, without compounding over periods. It's advantageous for borrowers due to lower costs, but remember it provides only a basic cost idea, not including other fees.

What Is Simple Interest?

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