Simple interest = (principal amount) * (interest rate) * (# of periods)
Simple interest basically refers to the simplest method of calculating the total interest paid on a principal sum of money loaned to, or by others. Understanding how to calculate simple interest is one of the foundational steps that you can take in order to understand and take charge of your finances.
It is almost impossible to escape the concept of interest in the modern world given the prevalence of credit cards, which are used by most people in developed countries such as the USA, to make purchases on a daily basis. Interest payments affect most people in developed countries who have mortgages, car loans, and credit card debt, all of which charge interest on the funds lent to the affected individuals.
Most lenders charge simple interest on car loans and other short-term loans, but use more complicated methods to calculate interest charges on long-term loans such as mortgages.
Comparison of Simple Interest vs. Compound Interest
When you are repaying a loan with simple interest, your monthly payment first pays for the monthly interest charge, and then the remaining amount pays a portion of the principal. The defining characteristic of such loans is that the monthly payment must fully pay for the monthly interest charge, therefore, the interest charges never accrue.
However, the interest payments on a loan with compound interest keep rising each month as this method typically adds new interest payments to the loan each month such that you pay interest on the previous interest each month. This might seem complicated, but we’ll cover compound interest in a separate article.
Limitations to Using Simple Interest Calculations
Simple interest is best suited for calculating the interest on short-term loans, however, when it comes to calculating the interest on long-term loans such as mortgages, using simple interest may actually prove more expensive. Most lenders calculate mortgage rates using compound interest rates, which are more precise as compared to simple interest calculations.
Remember that some short-term lenders might quote a fixed annual percentage rate (APR) on their loan. Most borrowers assume that APR works just like simple interest, but there is a slight variation because such lenders usually charge interest on a daily basis. This means that early repayments may attract lower interest charges, while late payments may attract higher interest charges. This is how most credit cards work.
Example and Benefits of Simple Interest Charges
For example, if you deposit $1,000 in an interest earning account with a bank that pays 5% interest on an annual basis, your interest earnings would be calculated as follows:
Simple interest = $1,000 * 0.05 * 1 = $50
This means that you would earn $50 each year as interest on your deposit, which means that if you left the money in the account for ten years, you would earn a total interest of $500.
However, compound interest works differently as the interest earnings typically increase each year as the bank will also pay interest on the interest earned previously. Therefore, compound interest is more beneficial for savers as they get to earn more than if they used simple interest.
Simple interest usually benefits borrowers who pay their loans early, while increasing the payments for parties who pay their loans late, hence, putting them at a disadvantage.