What is Simple Interest and How is it Calculated?
There is a high probability that you will encounter simple interest at some point in your life, as you navigate financial endeavors. In fact, you may be currently earning interest on your savings account or being charged interest on your credit card, whether you’re aware of it or not. But what is “simple interest?” Furthermore, how can you calculate simple interest and know what a reasonable rate is, and exactly how much you are earning or paying?
It is essential to know the answers to these questions when trying to understand finances, whether you’re making money off interest, or trying to understand how much extra you’ll need to pay on top of the principal amount of a loan.
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Simple Interest Loans
You may be charged simple interest on car loans, major appliance purchases, student debt, and even mortgages. While simple interest is easier to understand and calculate than compound interest, it still can get pretty complicated.
Simple interest is defined in the Cambridge Dictionary as “money that is paid only on an original amount of money that has been borrowed or invested, and not on the extra money that the original amount earns.” In essence, you will be charged simple interest (on top of your principal loan) at a rate determined by the lender, for borrowing their money for a period of time. This type of interest can be best explained by example.
Imagine yourself as the lender, distributing a $1,000 principal loan to a borrower so that they can buy a car, washing machine, etc. If you charge an 8% simple interest rate over one year, the borrower will then have to pay you back the principal loan amount ($1,000) as well as 8 percent on the principal investment ($80) — netting you, as the lender, a total of $1,080 when the loan repayment is due (a year from the loan date.) If the same principle rate were set for two years, the interest would be $160, and the total amount owed back to the lender would be $1,160, and so on.
How to Calculate Simple Interest
Knowing exactly how much interest you’ll pay or earn can help you make a sound decision on a simple interest loan. If you can quickly tally how much interest you’ll be paying or paid, you can tell if that car loan, refrigerator, or mortgage is the right decision for you. Calculating simple interest involves a little math. Fortunately, there is a formula for finding simple interest, and even simple interest calculators for simple interest loans with slightly more complex terms.
Simple Interest Formula
You may have learned — and forgotten — how to calculate simple interest in middle school math or high school algebra. The simple interest formula is: Interest = Principal x rate x time, or I = Prt, whereas:
- I = Interest.
- P = Principle.
- r = rate.
- t = time in years.
Using the example above, where you are the lender of a $1,000 loan, we can find the amount of interest you would be owed if we use this formula. I = 1,000 (P) x .08 (r) x 1 (t). $1,000 x .08 x 1 = $80 of interest. Remember that the total amount owed will be $80 plus the principal loan, totaling $1,080. Using the I = Prt formula, you can plug your principle, rate, and time in to find out how much money you will have to pay or be paid on a loan.
Simple Interest Calculator
Simple interest loans can quickly become complicated. Loans can be much more than $1,000, your rate can be a fraction of a percent, and your time frame can exceed 30 years. If you know your principal loan, rate, and time, a simple interest calculator can give you your yearly interest, total interest, and the overall balance you will have to pay or will be paid, over however many years of the repayment period are left.
The notion of interest can get complicated. However, with the right knowledge and tools, such as simple interest formula or calculator, you can plug in and rearrange numbers to: find interest, figure the interest rate, discover the principal loan, understand the total balance that needs to be paid, know how many years it will take to pay off your loan, and break down how much you will need to pay monthly and daily. Understanding simple interest may be the first step in understanding more comprehensive types of interest, such as compound interest or APR.
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Desmond Rhodes is a writer out of the Northwest. A philosopher, gamer, and enjoys his Hunter S. Thompson.
This post was updated April 22, 2019. It was originally published April 24, 2019.