What is simple interest and how is it calculated?

Simple interest is a term you might have heard before, but you might not fully understand how it works. It differs from its more complex cousin, compound interest. Just as its name infers, it’s relatively simple.

Simple interest is an interest amount based on the principal of a loan. The principal of a loan is the full amount you borrowed from a lender. This quick guide will help you understand what simple interest means for your money.

Simple interest doesn’t account for multiple periods of interest payments or charges and isn't affected by any interest accrued. 

You can calculate simple interest on your own using the following formula: 

Simple Interest = Principal x Interest Rate x Time

Let's take a look at an example of how to calculate simple interest. Let's say you take out a personal loan worth $5,000 with a 6.3% interest rate for five years. You can figure out simple interest by using the formula we introduced in the previous section: 

Simple Interest = Principal x Interest Rate x Time

Simple Interest = $5,000 x 0.063 x 5

Simple Interest = $1,575

In this case, you'd pay $1,575 in simple interest over the course of five years with this particular $5,000 personal loan. 

The simple interest rate formula is used for most common consumer debts, including auto loans, credit cards, student loans and mortgages. 

When you borrow, lend or deposit money, simple interest can apply because you must repay the amount you borrow and pay the cost of borrowing money. Lenders set an interest rate in exchange for borrowing money. On the other hand, lenders pay you interest because you make your money available to the lender so they can, in turn, lend to others.

Let's introduce a more complex type of interest — compound interest. Simple interest does not take into account the power of compounding, which is interest that builds on interest. 

While simple interest is calculated on the principal loan amount, compound interest is different. It's calculated on the principal amount and the accumulated interest of previous periods, which is where the "interest on interest" concept comes from.

If you’re interested in trying your hand at calculating it yourself, here is the formula for compound interest:

Future value of the investment = P(1 + r/n)^nt

P = principal balance

r = interest rate

n = the number of times interest is compounded per time period

t = number of time periods

Let's take a look at how to calculate this. Let's say $5,000 goes into an account that offers an annual return of 5% compounded monthly. Let's calculate the value of the investment after 10 years.

P = 5,000

r = 5% = 0.05

n = 12

t = 10

Future value of the investment = 1,000 (1 + 0.05 / 12) (12 * 10) = 1,647.01

In this case, the investment balance after 10 years is $1,647.01 using compound interest.

The Rule of 72 is a simplified formula that calculates how long it'll take for an investment to double in value. It's completely based on the rate of return.

The simple interest calculation gives you a simple way of looking at interest. It’s an introduction to the concept of interest in general. In the real world, interest is more likely calculated using more complex methods, such as compound interest.

Other costs may factor into a loan than just interest, which can affect the total amount that you spend on a loan. 

It’s good to know whether you’re dealing with simple or compound interest when adding up the cost of a loan or the potential to grow your money in savings.

From a savings or investing perspective, compound interest is better. But if you’re a borrower, simple interest will generally cost you less. Either way, knowing the difference between simple interest and compound interest is important for your bottom line.