Definition and Examples of Simple Interest
Interest represents a fee you pay on a loan or income you earn on deposits. Simple interest is a way of measuring interest that does not account for multiple periods of interest payments or charges. The interest rate will only apply to the principal amount of the loan or investment—it won't be affected by any interest accrued.
For example, say you invest $100 (the principal) at a 5% annual rate for one year. The simple interest calculation is:
- $100 x .05 interest x 1 year = $5 simple interest earned after one year
Note that the interest rate (5%) appears as a decimal (.05). To do your own calculations, you will need to convert percentages to decimals. For example, to convert 5% into a decimal, divide five by 100 to get .05.
An easy trick for remembering this is to think of the word percent as "per 100." You can convert a percentage into its decimal form by dividing it by 100. Or, just move the decimal point two spaces to the left.
If you want to calculate simple interest over more than one year, calculate the interest earnings using the principal from the first year, multiplied by the interest rate and the total number of years.
- $100 x .05 interest rate x 3 years = $15 simple interest for three years
Simple Interest Formula
To calculate simple interest, multiply the principal amount by the interest rate and the time. The formula written out is "Simple Interest = Principal x Interest Rate x Time."
This equation is the simplest way of calculating interest. Once you understand how to calculate simple interest, you can move on to other calculations, such as annual percentage yield (APY), annual percentage rate (APR), and compound interest.
Using Calculators
If you don't want to do these calculations yourself, you can use a calculator or have Google perform calculations for you. In Google, just type the formula into a search box, hit return, and you'll see the results. For example, a search of "5/100" will perform that same function for you (the result should be .05).
For a complete simple interest calculation, use a spreadsheet template in Google Sheets.
How Simple Interest Works
Understanding simple interest is one of the most fundamental concepts for mastering your finances. It involves some simple math, but calculators can do the work for you if you prefer. With an understanding of how interest works, you become empowered to make better financial decisions that save you money.
Interest can affect you in various aspects of your financial life:
- When borrowing money: You must repay the amount you borrowed and include payments for interest, which represents the cost of borrowing.
- When lending money: Lenders typically set a rate and earn interest income in exchange for making money available to other people.
- When depositing money: Interest-bearing accounts, such as savings accounts, pay interest income because you are making your money available to the bank to lend to others.
Simple Interest vs. Compound Interest
Simple Interest | Compound Interest | |
Complexity | Simple formula | Complex formula |
Effect of Time | Remains consistent | Costs grow over time |
For loans such as 30-year mortgages, for example, simple interest calculations aren't an entirely accurate way to compute your costs since they don't account for closing costs, which may have an impact on your APR.
The effects of compounding become more pronounced over time, and that's another reason why a 30-year mortgage is a bad candidate for simple interest calculations. Throughout the 30-year life of the loan, the interest costs will add significantly to the total cost paid by the borrower.
When you start accounting for compounding, you need to use more complex interest calculations that measure "compounding frequency," or how often the interest is compounded. This could be daily, monthly, yearly, or some other frequency. Each frequency would give different results.
For example, when you borrow funds with a credit card, you might estimate how much interest you pay using simple interest. However, most credit cards quote an annual percentage rate (APR) to customers, but they actually charge interest daily, and each day's total of principal and interest becomes the basis for the next interest charge. As a result, you accumulate a lot more in interest charges than you would tally with a simple interest calculation.
Limitations of Simple Interest
The simple interest calculation provides a very basic way of looking at interest. It’s an introduction to the concept of interest in general. In the real world, your interest—whether you’re paying it or earning it—is usually calculated using more complex methods.
There may also be other costs factored into a loan than just interest. These costs will affect the total amount that you spend on the loan throughout the year, but they may not be included in the interest rate given to you by the lender.
Key Takeaways
- Simple interest is the most basic way to calculate the cost of debt.
- To calculate simple interest, multiply the principal amount by the interest rate and measurement period.
- Simple interest works best for making rough estimates, whereas compound interest is more exact.