Simple Interest: Overview and Calculations
How Simple Interest Works With Your Money
Understanding simple interest is one of the most important and fundamental concepts for mastering your finances. It involves some simple math, and calculators can do the work for you if you prefer. With an understanding of how interest works, you can make better, money-saving financial decisions.
Defining Simple Interest
Simple interest represents a fee 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, which represents the cost of borrowing.
- When you lend money or deposit funds in interest-bearing accounts like savings accounts, you typically earn interest income for making your money available to other people.
Interest is that additional money—the extra amount you pay or earn—and it’s calculated based on the original sum of money, known as the principal.
In this example, 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.
How to Calculate: An Example
To calculate simple interest, use this formula:
Simple interest = (principal) * (rate) * (# of periods)
For example, you invest $100 (the principal) at a 5-percent annual rate for 1 year. The simple interest calculation is:
Simple interest: ($100) * (.05) * (1) = $5 simple interest for one year
Note that the interest rate (5 percent) is written as a decimal (.05). To do your own calculations, you'll need to convert percentages to decimals. Remember this easily by thinking of the word percent as "per 100." You can convert a percentage into its decimal form by dividing by 100. For example:
Convert 5 percent into decimal= 5 percent / 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 you want to calculate simple interest 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.
Limitations of Simple Interest
Simple interest provides 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 slightly more complex methods. However, understanding simple interest gives you a good start, 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 that involves compounding, for example.
More complex interest calculations involve something called 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 they actually charge interest daily. As a result, you'll owe a lot more than you would think if you relied only on a simple interest calculation.
For a more accurate explanation of credit card calculations, see how your payments and interest charges affect your card balance.
Keep in mind 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 account 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.
You can 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. You may also want to investigate how to use spreadsheets (like Excel or Google Sheets) to calculate loans.