Simple Interest: Overview and Calculations
How Simple Interest Works With Your Money
Simple interest is one of the most important concepts for mastering finances. Some math is involved but it is not complex, and calculators can do the work for you if you prefer. With an understanding of how interest works, you can make better financial decisions.
Simple Interest Overview
Simple interest is money that you pay on a loan or income that you earn on deposits.
- When you borrow money, you have to repay the amount you borrowed and make extra payments for interest.
- When you lend money (or deposit funds in interest-bearing accounts like savings accounts), you typically earn income for making your money available to other people.
Interest is that additional money—the extra amount you pay or earn—and it is calculated based on the original sum of money (known as the "principal").
The term "simple" means you're working with the simplest way of calculating interest. Once you understand how to calculate simple interest, you can move on to other varieties, like annual percentage yield (APY), annual percentage rate (APR), and compound interest.
Simple Interest Formula
To calculate simple interest, use this formula:
I = P x r x t
Explanation: Simple interest (I) is calculated by multiplying Principal (p) times the Rate (r) times the number of Time (t) periods.
Example: You invest $100 (the principal) at a 5% annual rate for 1 year. The simple interest calculation is:
- P x r x t = I
- $100 x 5% x 1 year = $5
- $100 x .05 x 1 year = $5
Note that the interest rate (5%) is written as a decimal (.05). To do your own calculations, you'll need to convert percentages to decimals. An easy way to remember how is to think of the word "percent" as "per 100." Then you can convert a percentage into its decimal form by dividing by 100.
5 divided by 100 = .05
Note that it is not 5% divided by 100, it's simply 5. So:
5 / 100 = .05
Calculators: If you don't want to do these calculations yourself, you can use a calculator, spreadsheet, or have Google perform calculations for you. 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 answer should be .05).
Multiple years: If simple interest will be calculated over more than 1 year, calculate the interest earnings using the principal from the first year. In other words, don’t increase the principal every year, unless you’re switching to compound interest instead of simple interest.
Simple Interest Limitations
Simple interest is a basic way of looking at interest. In the real world, your interest—whether you’re paying it or earning it—is usually calculated using different methods. However, simple interest is a good start (and an important building block), and it can give you a general idea of what a loan will cost or what an investment will return.
As the time period involved grows longer (if you're dealing with a 30-year mortgage instead of a 1-year bank deposit, for example), simple interest calculations become less accurate than using the actual method — using compounding, for example.
The same is true of "compounding frequency." For example, when you borrow 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), but interest is charged daily. As a result, you'll owe a lot more than you can imagine if you use a simple interest calculation. For a more accurate explanation of credit card calculations, see how your payments and interest charges affect your card balance.
The main thing to keep in mind is that simple interest does not take compounding into account. Compounding is the repetitive process of earning (or paying) interest, adding that interest to your principal balance, and earning even more interest in the next round due to that increased balance.
Now that you know how simple interest works, you can look at more complex types of interest.
Most of them are a variation of simple interest, or they repeat the calculations multiple times throughout the life of a loan.
Start by familiarizing yourself with APY, which accounts for compounding.
You can also see how much interest you pay when borrowing money. Running some numbers on your debt may motivate you to borrow less and repay loans more quickly.
- See how to use spreadsheets (like Excel or Google Sheets) to calculate loans.
- Learn more about paying off debt early.