Understanding simple interest is one of the most important and 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 is the fee paid on an amount of money, whether it's loaned, borrowed, or invested. Note that simple interest does not take compounding into account. Compounding is the repetitive process of earning (or paying) interest, adding that interest to the principal balance, and adding even more interest in the next period due to that increased account balance.
Defining Simple Interest
Simple interest represents a fee you pay on a loan or income you earn on deposits.
- When borrowing money: You must repay the amount you borrowed and make extra payments for interest, which represents the cost of borrowing.
- When lending money: You typically set a rate and earn interest income in exchange for making your money available to other people.
- When depositing money: Interest-bearing accounts such as savings accounts pay interest income because you are making money available to the bank to lend to others.
How to Calculate It
In the following example, 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 calculations, such as annual percentage yield (APY), annual percentage rate (APR), and compound interest.
Simple interest is calculated only on the original sum of money, which is known as the principal.
To calculate simple interest, use this formula:
Principal x rate x time = interest
For example, say you invest $100 (the principal) at a 5% annual rate for one year. The simple interest calculation is:
$100 x .05 x 1 = $5 simple interest for one year
Note that the interest rate (5%) appears as a decimal (.05). To do your own calculations, you may need to convert percentages to decimals. 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. For example, to convert 5% into a decimal, divide 5 by 100 and get .05.
If you want to calculate simple interest over more than 1 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 x 3 = $15 simple interest for three years
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).
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.
However, understanding simple interest is a good start, and it can provide you a broad idea of what a loan will cost or what an investment will return.
More complex interest calculations involve something called compounding frequency, which is how often the interest is compounded—daily, monthly, yearly, or some other frequency.
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) but actually charge interest daily, with the total of principal and interest used as 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.
Understanding simple interest is a necessary stepping stone in managing your finances. It is not the final step but leads to more complex financial concepts.