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Simple interest is the calculation used to determine how much it costs to borrow money at a set rate over a certain period of time. You can also use simple interest to figure out how much you can earn in some savings accounts or investments.

Credit cards, car loans, and mortgages often use simple interest to determine your monthly interest payments. Understanding how to calculate simple interest can significantly impact your financial strategy and help you to make more informed decisions.

Keep reading to learn what simple interest is, how it’s different from compound interest, and how to calculate simple interest when you need it.

What is simple interest?

Simple interest is a calculation that determines how much interest you’ll pay based on the:

  • Original loan or principal amount
  • Interest rate
  • Period over which the loan or investment is made

Unlike compound interest, which calculates interest on the initial principal and the accumulated interest of previous periods, simple interest is only charged on the principal amount

Simple interest is commonly used for short-term loans or investments where the interest is not compounded.

The simplicity of this calculation makes it transparent and predictable for borrowers and investors alike, providing a clear understanding of the interest charges or earnings over a specified period.

Simple interest is often more favorable for borrowers in short-term scenarios because it results in lower total interest payments than compound interest, assuming the same rate and term conditions​​​​.

Simple interest formula

The formula for calculating simple interest is:

Interest = Principal x Rate x Time (I = PRT)

  • Interest (I): the total interest paid or earned.
  • Principal (P): the original sum of money borrowed or invested.
  • Rate (R): the annual interest rate (in decimal form).
  • Time (T): the time the money is borrowed or invested, typically in years.

For example, if you invest $1,000 at an annual simple interest rate of 5% for three years, the interest earned would be calculated as follows:

Interest = $1,000 x 0.05 x 3 = $150

Therefore, the total interest earned over three years would be $150, making the total amount $1,150.

Tips for reducing interest

Understanding how to calculate simple interest on a loan or investment is step one. After you’ve mastered this, you can look for ways to minimize the impact of simple interest when you borrow and maximize interest when you invest.

  • Review loan agreements: Take time to check if a loan utilizes simple or compound interest. Simple interest is often less costly over time for loans, such as auto or short-term personal loans.
  • Negotiate terms: For loans, negotiating a lower interest rate or a shorter term can reduce the total interest paid. Having a higher credit score and a steady source of income may help you negotiate a lower rate.
  • Pay attention to investment opportunities: When investing, compound interest is typically more beneficial as it helps you earn more over time. Before investing, understand if simple or compound interest is used to calculate your returns.
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Loans that use simple interest

Several types of loans typically utilize simple interest calculations, including:

  • Auto loans: Many auto loans calculate interest simply, based on the principal balance of the loan.
  • Personal loans: Short-term personal loans might use simple interest to determine the cost of borrowing.
  • Student loans: Some student loans, especially federal student loans, calculate simple interest which can be beneficial for borrowers who pay on time or early.²
  • Mortgage loans: Most mortgages also use simple interest. If you’re able to make an extra mortgage payment, this can help to lower the principal amount and your interest payments.

Understanding which loans use simple interest can help you plan your finances more effectively and potentially help you save on interest costs over the life of the loan​​.

Comparing simple interest and compound interest

The primary difference between simple and compound interest is how they are calculated and the overall amount of interest paid or earned.

Simple interest

Simple interest is calculated on the principal amount alone, making it straightforward and predictable.

Simple interest is ideal when borrowing money because you only pay interest on the principal loan amount. As you pay off more of your loan and the principal amount decreases, so do your interest payments.

Compound interest

Compound interest is calculated on the principal amount plus any interest you’ve earned, which can significantly increase the interest amount over time.

Compound interest is ideal for saving or investing because it helps you grow your money faster.

However, if you borrow money with compound interest, you’ll pay more interest over time.

The downsides of simple interest

While simple is advantageous in certain scenarios, it also has its downsides, particularly regarding investing.

Simple interest does not capitalize on the power of compounding, potentially resulting in lower overall returns on long-term investments.

Additionally, for borrowers, simple interest loans might not always be available for longer terms or larger amounts.

Calculating simple interest is simple

Understanding simple interest is helpful for making informed financial decisions.

While it offers benefits like lower costs for borrowers and straightforward calculations, consider all aspects of interest charges on loans or earnings on investments.

Next, learn more about annual percentage rates (APR) on credit cards, which can affect how much you pay in interest.

FAQs

What is the simple interest rate definition?

Simple interest is the calculation used to determine how much it costs to borrow money at a set rate over a certain period of time. It’s also used to determine how much you can earn in some savings and checking accounts or investments.

What is the formula for calculating simple interest?

The formula for calculating simple interest is: Interest = Principal x Rate x Time (I = PRT).

Which will pay out more over time, simple or compound interest?

Compound interest typically pays out more over time because it calculates interest on the accumulated interest and the principal. Simple interest only calculates interest on the principal.

Who benefits from simple interest?

Borrowers can benefit from simple interest on short-term loans, as it may result in lower total interest payments than loans with compound interest.

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¹ Information from the Corporate Finance Institute's "Simple Interest," as of February 29, 2024: https://corporatefinanceinstitute.com/resources/commercial-lending/simple-interest-definition/

² Information from Federal Student Aid's "Interest rates and fees for federal student loans," as of February 29, 2024: https://studentaid.gov/understand-aid/types/loans/interest-rates#how-calculated

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