Simple Interest Explained
With this formula, simple interest is, well, simple.
Interest, in the most basic terms, is the cost of borrowing money. It’s the percentage you pay to your lender when you use a credit card or take out a loan. However, interest can also be paid to you—common ways to earn interest include savings accounts and certificates of deposit.
One method of assessing interest is called compound interest, and it consists of applying interest to a sum of money as well as the interest that sum of money has accrued. The other method, simple interest, applies interest only to the initial amount of money borrowed or deposited.
Understanding how interest is calculated will help you make more informed decisions when taking out a loan, using credit, and investing. If you have questions about simple interest, we have answers.
Simple Interest Definition
What is simple interest? Not to be confused with compound interest, simple interest is interest that is applied only to the original amount of money borrowed or deposited, also known as the principal. Most types of mortgages, car loans, personal loans, and credit cards rely on simple interest in their calculations.
Simple Interest Formula
We spoke to Jim Wasserman, a retired economics and media literacy teacher, to learn how simple interest is applied to our everyday lives.
“I explained simple interest to my students as being neat as a PIN,” Wasserman said. “P = principal or loan amount. I = interest rate (one is charged per period). N = number of periods that the loan lasts.”
Thus, to calculate simple interest, you multiply the principal by the interest rate by the amount of time that interest is accrued.
The formula is often written as this:
I = Prt
Since you’re only paying interest on the lump sum, it’s fairly easy to calculate.
An Example of Simple Interest
Here’s a story about Wasserman’s two sons that demonstrates one way in which simple interest is used:
Journey wants to buy a drink at the store, but doesn’t have any money. He asks his older brother, Ben, if he can borrow money. Ben says he’ll lend Journey the $2, but he will need to be paid back the $2 plus 20 cents for each day that he is kept waiting. And not to tell their parents!
Journey takes four days to pay back Ben. With all of this information, we can easily calculate how much he owes by using the simple interest formula.
The principal amount is $2. The interest is 10 percent—20 cents divided $2.00. The number of periods that interest is accrued is four days.
This means that the simple interest formula for this example is 2 x .10 x 4 = .80. Add the 80 cents of interest to the principal amount and Journey owes Ben $2.80.
“The simplicity of doing interest this way, and teaching Journey about interest, was outweighed in my mind by the rule, and this was STRONGLY conveyed to Ben, that family members should not use other family members’ situations for personal gain, but should help them out!”
Is Simple Interest Good or Bad?
This leads to an important question: Is simple interest good or bad? The answer? It depends.
“[S]imple interest is a tool, like a hammer,” Wasserman said. “It is neither good nor bad by itself; it’s all on how it is used.”
Essentially, simple interest is good if you’re the one paying the interest, because it will cost less than compound interest. However, if you’re the one collecting the interest—say, if you have money deposited in a savings account—then simple interest is bad. With compound interest, you’d receive interest on the interest that you earn. This isn’t the case with simple interest.
Simple interest is one way that interest can be assessed. If you’re borrowing money, it’s better than compound interest. If you’re collecting interest, it’s worse.
Ready to make some calculations? I = Prt is the formula you need.
Jim Wasserman taught economics and media literacy for over 20 years. Retired from the classroom, he continues to write on education, economics, media literacy, and financial literacy. He has a three-book series, “Media, Marketing, and Me” (teacher’s guides for introducing media literacy and behavioral economics to elementary, middle, and high school students) coming out this year. With his wife and two feline overlords, he also maintains a blog, yourthirdlife.com, about wandering and wondering about the world in retirement.
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