Have you ever wanted to gain a better understanding of how simple interest works? This guide has you covered and once you’re finished reading, you’ll understand what goes into the simple interest calculation and how to compute figures for your financial products.
A Closer Look at How Simple Interest Works
Simple interest is defined by Merriam-Webster as “interest paid or computed on the original principal only of a loan or on the amount of an account.” In other words, it’s how much you pay the lender in interest on a loan, earn in interest on a loan made to others, or generate from earnings on the money in a savings account.
Simple Interest on Loans
As mentioned earlier, if you borrow from a financial institution, the simple interest is the amount paid in addition to the principal. But if you’re on the other end of the equation as a lender, the rate you assess to borrowers is also known as simple interest.
Simple Interest on Deposits
When you deposit money into a savings account, it has the ability to grow through simple interest earnings. Why so? Well, banks will pay you a small percentage of your funds in exchange for the ability to house your funds in their arsenal and loan them out to others.
Key Benefits of Simple Interest Loan Products
- Easier to pay off debt products faster since overpayments ding the principal balance rapidly and lowers the interest expense
- A consistent monthly payment on debt products
- Interest not paid on interest
- More cost-efficient than compounding interest debt products
How to Calculate Simple Interest
While you can always search for a simple interest calculator online to run the numbers, it’s a good idea to be knowledgeable of the formula so you can perform computations on the fly if needed.
The Simple Interest Formula
The formula to calculate simple interest is as follows:
Simple Interest = (principal) * (rate) * (# of periods)
Scenario #1: Simple interest earned on a high-yield savings account.
If you deposit $3,000 into a high-yield savings account that pays 3% annually, you’ll earn $90 in simple interest in the first year. To reach this figure, you would use the following calculation:
Inputs
- Principal- $3,000
- Rate- .03
- Number of Periods- 1 (compounding annually)
Final Calculation
($3,000) * (.03) * (1) = $90
Curious to know what earnings would be over a two-year, five-year, or even ten-year span assuming you didn’t deposit any additional money? Simply change the number of periods in the formula and you’re all set. This is demonstrated below:
Final Calculation for Earnings Over Two-Years
($3,000) * (.03) * (2) = $180
Final Calculation for Earnings Over Five-Years
($3,000) * (.03) * (5) = $450
Final Calculation for Earnings Over Ten- Years
($3,000) * (.03) * (10) = $900
Scenario #2: Simple interest paid to a lender for a personal loan.
Assume you take out a six-month personal loan for $5,000 with a rate of 10 percent. The inputs and calculations for simple interest are listed below.
Inputs
- Principal- $5,000
- Rate- 10%
- Number of Periods- .5
Final Calculation
($5,000) * (.10) * (.5) = $250
If you pay off the loan three months early (assuming no prepayment penalties apply):
($5,000) * (.10) * (.25) = $125
Scenario #3: Simple interest earned on a loan made to a relative or friend.
You decide to extend a small personal loan of $1,000 to a relative for three short months. To be fair, you charge an interest rate of 5 percent. The inputs and calculation for simple interest are listed below:
Inputs
- Principal- $1,000
- Rate- 5%
- Number of Periods- .25
Final Calculation
($1,000) * (.05) * (.25) = $12.50
An Important Consideration
While the simple interest formula gives you a basic understanding of how interest works, it’s not necessarily the most ideal way to measure how much you’ll actually pay or earn in interest. Why so? Well, it depends on the loan or deposit product.
Some financial institutions offer simple interest products while others compute interest liability or earnings through compounding. For the latter, interest is paid or earned on top of interest. In other words, the amount you pay or earn isn’t solely based on the principal balance.
You may find banks that offer short-term personal loans, student loans, auto loans, mortgage loans, and high-yield savings accounts that use the simple interest formula. However, some long-term loans and most savings accounts use compound interest, instead. And credit cards compound interest daily, so you can expect to pay a substantial amount in interest over time if you don’t eradicate the outstanding balance sooner than later.
Quick note: regardless of the account type, you’ll need to determine if the interest compounds daily, monthly, or yearly, to properly calculate the simple interest figure.
The Bottom Line
Simple interest is best if you’re on the borrowing side of the equation because you won’t be forced to pay interest on top of interest. However, if compounding interest may be the better choice if you’re investing and hoping to earn a return.