What Is Simple Interest? Simple interest is the cost of borrowing money that does not consider compounding. In other words, just the principal is affected by simple interest.
Definition and Examples of Simple Interest
A fee you pay on a loan or revenue you receive from deposits is represented by interest. Simple interest is a method of calculating interest that does not take into consideration numerous periods of interest charges or payments. The interest rate will not be modified by any interest accrued. It will only apply to the principal amount of the loan or investment.
Consider making a $100 (the principal) investment at a 5% yearly rate for a year. The formula for calculating interest is:
- $100 x .05 interest x 1 year = $5 simple interest earned after one year
The interest rate (5%) is displayed as a decimal, as you can see (.05). You must convert percentages to decimals to perform your computations. For instance, divide five by 100 to obtain.05. This is the decimal equivalent of 5%.
When calculating simple interest over some time longer than one year, multiply the principal from the first year by the interest rate. And the overall number of years to arrive at the interest earnings.
- $100 x .05 interest rate x 3 years = $15 simple interest for three years
Simple Interest Formula
Simple interest is calculated by multiplying the principal by the time, and interest rate. And period. “Simple Interest = Principal x Interest Rate x Time” is the written formula.
The simplest method for computing interest is using this equation. Simple interest can be calculated using a variety of formulas, including annual percentage yield (APY). Annual percentage rate (APR), and compound interest.
Using Calculators
You can use a calculator or ask Google to make the calculations for you if you don’t want to do them yourself. Simply enter the formula into a Google search box, press return, and the results will appear. For instance, a search for “5/100” will accomplish the same task for you (the result should be .05).
How Simple Interest Works
One of the most essential ideas for mastering your finances is simple interest. Simple math is required, but if you’d rather, calculators can complete the task for you. Knowing how interest works empowers you to make wiser financial decisions that result in cost-saving measures.
It may have an impact on you in several areas of your financial life:
When borrowing money: You must pay back the money you borrowed plus interest, which is the cost of borrowing when you borrow money.
When extending credit: In exchange for making money available to other individuals, lenders often set a rate and get interest payments.
While making a deposit: Savings accounts and other interest-bearing accounts pay interest because you are allowing the bank to spend your funds.
Simple Interest vs. Compound Interest
| Simple Interest | Compound Interest | |
| Complexity | Simple formula | Complex formula |
| Effect of Time | Remains consistent | Costs grow over time |
Simple interest calculations aren’t always an accurate way to determine your costs for loans like 30-year mortgages, for instance. Because they don’t take closing fees into consideration, which could affect your APR.
Use more intricate calculations that gauge “compounding frequency.” Or how frequently it is compounded after you start accounting for compounding. This could happen daily, weekly, monthly, or yearly. Or another basis. Results would vary depending on the frequency.
For instance, you could use simple interest to calculate the amount of interest you will pay while borrowing money with a credit card. However, although most credit cards advertise an annual percentage rate (APR) to clients. They charge daily, with the sum of the daily principal. And it determines the actual APR basis for the next charge. As a result, you accumulate a lot more charges than you would tally with a simple interest calculation.
Limitations of Simple Interest
The straightforward interest computation offers a very fundamental perspective on it. It serves as a general introduction to the idea of interest. In the actual world, the processes used to calculate interest—whether you’re earning it or paying it—are typically more intricate.
In addition to it, a loan may also include extra expenses. Although they might not be factored into the interest rate that the lender gave you. These expenses will have an impact on the overall amount that you pay back on the loan over the year.
Check Also:
How Does A Home Equity Loan Work?
What Is The Best Long-Term Care Insurance?
What Is Renters Liability Insurance?
