While simple interest is a relatively straightforward concept, it’s important to understand what exactly simple interest means for your money before you borrow or save.
Read more: How the power of visualization can help you with your savings goals
What is simple interest?
Simple interest is calculated on a principal amount. It can be applied in two different ways:
Interest on borrowed money: When you borrow money, you pay interest. For example, if you take out a loan and it applies simple interest, the interest is charged on the initial balance of your loan (the principal).
Interest on deposit accounts: Simple interest can also be earned on deposit accounts, such as a savings account or certificate of deposit (CD). If your deposit account earns simple interest, the interest paid is calculated by just the deposit amount.
Key features of simple interest
Because this type of interest doesn’t compound over time, simple interest is known for its:
Linearity: Interest grows at a constant rate over time, making projections simple and intuitive.Predictability: You always know exactly how much interest will accrue, which can reduce uncertainty and aid in planning.
How to calculate simple interest
Use the following formula:
Simple Interest = Principal x Interest Rate x Time
Example of simple interest calculations
Let's say you take out a personal loan worth $5,000 with a 6.3% interest rate for five years:
Simple Interest = Principal × Interest Rate × Time
Simple Interest = $5,000 × 0.063 × 5
Simple Interest = $1,575
Simple interest vs. compound interest
Simple interest does not take into account the power of compounding, which is interest that builds on interest. you'll typically see compound interest when you generate a payout based on the amount you’ve saved in an account such as:
CDs
High-yield savings accounts
What is compound interest?
When this type of interest is added to your principal, the next interest calculation is based on your new, larger principal. This creates a snowball effect, where your money grows faster over time.
Key differences
While simple interest is calculated on the principal loan amount, compound interest is calculated on the principal amount and the accumulated interest of previous periods. This is where the "interest on interest" concept comes from.
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 withthis compound interest calculator.
Limitations of simple interest
The simple interest calculation gives you a straightforward way of looking at interest. It’s an introduction to the concept of interest in general. Keep in mind, it only gives a basic idea of cost that may not account for other charges and fees that a loan could include.
Keeping it simple
Taking control of your financial future starts with understanding the basics, including simple interest. By knowing how interest impacts your loans, savings and investments, you can help make more informed decisions about your money.
