With many things in life — your favorite recipes, your morning routine — it pays to keep things, well … simple. That’s especially true when it comes to borrowing money or saving it.
Simple interest is a term you might’ve heard before, but you might not fully understand how it works. Not to mention how it differs from its more complex cousin, compound interest.
Don’t worry — just as its name infers, it’s simple. In no time, this quick guide will help you understand what simple interest means for your money.
What is simple interest?
Without getting super jargon-y, simple interest is interest that’s calculated on the principal or the original amount. Simple interest can be applied in two different ways:
- When you borrow money, you pay interest. If your loan charges simple interest, interest is charged on the principal of your loan, or the initial balance.
- You can earn interest on deposit accounts, such as a savings account, money market account, or CD. If your deposit account earns simple interest, the interest paid is calculated on just the deposit amount.
How does simple interest work?
You can use the simple interest formula to calculate simple interest paid on a loan or earned on savings. The formula looks like this:
In this formula, P is the principal or the initial amount borrowed or saved. The r is the annual interest rate, expressed as a decimal, and t is the time period the interest is paid. (I, of course, is the total interest paid.)
So if you take out a $5,000 car loan with an 8 percent annual interest rate, you would pay $400 in total interest in one year.
Simple interest vs. compound interest
So what’s the difference between the two types of interest?
Simple interest is interest that’s calculated on the original principal only of a loan or on the amount deposited into a deposit account.
Compound interest is interest that’s calculated based on the unpaid principal and any interest that’s already accumulated. It’s essentially the interest on your interest.
Compound interest can compound daily, monthly, quarterly, or annually, depending on the terms of your loan or deposit account. The formula for calculating it is a little more complicated, so the easiest way to figure it out is with a compound interest calculator.
Knowing the difference is important
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 is important for your bottom line.
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