Simple Interest: Overview and Calculations
How it 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 financial decisions that save you money.
Defining Simple Interest
Simple interest represents a fee you pay on a loan, or income you earn on deposits:
- When borrowing money: You have to 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 for making your money available to other people.
- When depositing money: Interest-bearing accounts like savings accounts pay interest income because you are making money available to the bank to lend to others.
How to Calculate: An Example
Interest is calculated based on the original sum of money, known as the principal.
In the following 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.
To calculate simple interest, use this formula:
Simple Interest = (principal) * (rate) * (# of periods)
For example, you invest $100 (the principal) at a 5% 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%) 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% into decimal= 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 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 total number of years.
Simple Interest: ($100) * (.05) * 3 = $15 simple interest for three years
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, a 30-year mortgage, for example, simple interest calculations become less accurate than using the actual method involving compounding.
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 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 than you would tally with a simple interest calculation.
Keep in mind that simple interest does not take compounding into account. Again, 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.