Definition of simple interest

What is simple interest?

Simple Interest is a quick and easy way to calculate interest charges on a loan. Simple interest is determined by multiplying the interest rate by the principal by the number of days that elapse between payments.

This type of interest generally applies to auto loans or short-term loans, although some mortgages use this method of calculation.

Key points to remember

  • Simple interest is calculated by multiplying the daily interest rate by the principal, by the number of days between payments.
  • Simple interest benefits consumers who repay their loans on time or at the start of each month.
  • Auto loans and short term personal loans are generally low interest loans.

Understanding the simple interest

Understanding the simple interest

Interest is the cost of borrowing money. Usually expressed as a percentage, this is a commission or supplement that the borrower pays to the lender for the amount financed.

When you make a payment on a simple interest loan, the payment goes toward the monthly interest first, and the rest goes toward the principal. The interest for each month is paid in full, so that no accumulates. In contrast, compound interest adds a portion of the monthly interest on the loan; each subsequent month, you pay new interest on the old interest.

To understand how simple interest works, consider a car loan with a principal balance of $ 15,000 and an annual simple interest rate of 5%. If your payment is due on May 1 and you pay it precisely on the due date, the finance company calculates your interest on the 30 days of April. Your 30-day interest is $ 61.64 in this scenario. However, if you make the payment on April 21, the finance company charges you interest for only 20 days in April, which reduces your interest payment to $ 41.09, a savings of $ 20.

Simple formula of interest and example

The simple interest formula is pretty, well, simple. It looks like this:













Simple interest


=


P


×


I


×


NOT
















or:
















P


=


Main
















I


=


Daily interest rate
















NOT


=


Number of days between payments







begin {aligned} & text {Simple interest} = P times I times N & textbf {where:} & P = text {Principal} & I = text {Daily interest rate } & N = text {Number of days between payments} end {aligned}



Simple interest=P×I×NOTor:P=MainI=Daily interest rateNOT=Number of days between payments

As a general rule, simple interest paid or received over a certain period constitutes a fixed percentage of capital borrowed or loaned. For example, suppose a student gets a simple interest loan to pay for a year of college tuition, which costs $ 18,000, and the annual interest rate on the loan is 6%. The student repays the loan over three years. The amount of simple interest paid is:













$


3


,


240


=


$


18


,


000


×


0.06


×


3







begin {aligned} & $ 3.240 = $ 18.000 times 0.06 times 3 end {aligned}



$3,240=$18,000×0.06×3

and the total amount paid is:













$


21


,


240


=


$


18


,


000


+


$


3


,


240







begin {aligned} & $ 21.240 = $ 18.000 + $ 3.240 end {aligned}



$21,240=$18,000+$3,240

Who Benefits from a Simple Interest Loan?

Since simple interest is often calculated daily, it primarily benefits consumers who pay their bills or loans on time or earlier each month.

In the student loan scenario above, if you sent a payment of $ 300 on May 1, then $ 238.36 will go into principal. If you sent the same payment on April 20, then $ 258.91 will go into principal. If you can pay off earlier each month, your principal balance goes down faster and you pay off the loan sooner than the original estimate.

Conversely, if you pay off the loan late, more of your payment goes towards interest than if you pay it on time. Using the same car loan example, if your payment is due on May 1 and you make it on May 16, you will have to pay 45 days of interest at a cost of $ 92.46. This means that only $ 207.54 of your $ 300 payment goes towards principal. If you regularly pay late throughout the life of a loan, your final payment will be higher than the initial estimate because you haven’t paid back the principal at the expected rate.

What types of loans use simple interest?

Simple interest generally applies auto or short-term loans personal loans. In the United States, most mortgages on a Amortization schedule are also simple interest loans, although they can certainly feel like compound interest.

The impression of membership comes from the change in principal payments – that is, the percentage of your mortgage payment that actually goes to the loan itself, not the interest. Interest is not compounded; principal payments do. A principal payment of $ 1,000 saves interest on that $ 1,000 and results in higher principal payments the following year, higher principal payments the following year, and so on. If you don’t let the principal payments vary, such as with an interest-only loan (zero principal payment), or equalizing the principal payments, the interest on the loan itself does not compound. Lowering the interest rate, shortening the term of the loan, or prepaying the principal also have a cumulative effect.

For example, take bi-weekly mortgage payment plans. Bi-weekly plans typically help consumers pay off their mortgage sooner because borrowers make two more payments per year, saving interest over the life of the loan by paying off the principal faster.

If you are looking to take out a short term personal loan, then a personal loan calculator can be a great tool for determining in advance an interest rate that is within your means.

Simple interest vs compound interest

Interest can be simple or compound. Simple interest is based on the original the principal amount a loan or a deposit.

Compound interest, on the other hand, is based on the principal amount and the interest that accumulates in each period. Simple interest is calculated only on the principal, so it is easier to determine than compound interest.

In real life situations, compound interest is often a factor in business transactions, investments, and financial products intended to span multiple periods or years. Simple interest is mainly used for easy calculations: those usually for a single period or less than a year. Simple interest also applies to open situations, such as credit card balances.

Why is simple interest “simple”?

“Simple” interest refers to the direct credit of the cash flows associated with an investment or deposit. For example, an annual simple interest of 1% would credit $ 1 for every $ 100 invested, year after year. Simple interest, however, does not take into account the power of capitalization, or interest on interest, where after the first year, the 1% would actually be earned on the $ 101 balance, for a total of $ 1.01. The following year, the 1% would be earned on $ 102.01, or $ 1.02. And so on.

What will pay off more over time, simple or compound interest?

Compound interest will always pay more after the first payment period. Suppose you borrow $ 10,000 at an annual interest rate of 10% with the principal and interest due like a lump sum in three years. Using a simple interest calculation, 10% of the principal balance is added to your repayment amount in each of the three years. This works out to $ 1,000 per year, which represents $ 3,000 in interest over the life of the loan. On reimbursement, the amount due is then $ 13,000. Now suppose you take out the same loan, with the same terms, but the interest is compounded annually. When the loan matures, instead of $ 13,000, you owe $ 13,310. While you might not think of $ 310 as a huge difference, this example is only a three-year loan; compound interest accumulates and becomes oppressive with longer loan terms.

What are the financial instruments that use simple interest?

Most coupon bonds use simple interest. So do most personal loans, including student loans and auto loans, and mortgages.

What are the financial instruments that use compound interest?

Most bank deposit accounts, credit card, and some lines of credit will tend to use compound interest.

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