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Simple Interest Explained
Interest, in the most basic terms, is the cost of borrowing money. It’s the percentage you pay to your lender when you carry a balance on your 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 periodically applying a percentage rate of interest cost to an initial sum of money as well as the accumulated interest. 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 amount. No matter how often the interest charge is applied, it will only be applied to the initial amount. Many loans rely on simple interest in their calculations, but you’ll want to be certain before signing anything.
Simple Interest Formula
We spoke to Jim Wasserman, a retired economics and media literacy teacher, to learn how simple interest works in our everyday lives.
“I explained simple interest to my students as being neat as a PIN,” Wasserman says. “P = principal or loan amount. I = interest rate (one is charged per period). N = number of periods that the loan lasts.”
Thus, to calculate the total interest, you multiply the principal by the interest rate by the time period that interest is accrued.
The formula is often written as follows:
I = Prt
Since you’re only paying interest on the initial lump sum, it’s fairly easy to calculate.
Simple interest can be found in many places in the personal finance world. You might encounter it when taking out a personal loan, car loan, or setting up a bank account. The other type of interest you’re likely to come across is compound interest. Most loans and interest-bearing accounts will feature one or the other — it depends on the terms of the agreement.
Examples of Simple Interest
Bianca just graduated from college and is ready to buy her first car. She has enough for a downpayment but needs to borrow $20,000 to make the purchase. The loan she gets has an annual interest rate (assessed using simple interest) of 7% and a term of five years.
To determine how much she’ll pay in interest, Bianca will need to use the simple interest formula: I = Prt. Here, the equation will be 20,000 x .07 x 5. Crunching the numbers, Bianca finds that she’ll pay $7,000 in interest over the life of the loan.
Ayesha has $19,000 in savings and decides to deposit it in a savings account that offers a simple interest rate of 2 percent per year. To calculate how much she’ll earn, she multiplies $19,000 by 2% by one. This equation (19,000 x .02 x 1) tells her that at the end of the year she’ll have $380 in interest, bringing her account to $19,380. Some savings accounts offer some form of compound interest, however, which could offer Ayesha a better return.
Jose has $1,500 to invest and there’s a certificate of deposit at his bank that has caught his eye. It offers a 5-percent APR “Annual Percentage Rate” (simple interest) for a 24-month CD. “CD” stands for “certificate of deposit” and it’s a financial product that pays interest in exchange for you agreeing to deposit money for a certain number of years. It’s kind of like you’re lending money to the bank.
To determine how much he’ll make, Jose multiplies $1,500 by 5% by two years, or $1,500 x .05 x 2. With this formula he determines that the CD will pay him $150 at the end of its term, bringing his money to $1,650. In reality, however, most CDs offer compound interest, so both Jose and Ayesha may have considered shopping around a little more.
Simple Interest Worksheet
Ready to become a human simple interest calculator? Use our simple interest worksheet to find the amount of interest in the following simple interest scenarios.
- Alexander needs money for a necessary medical expense. He takes out a personal loan of $2,000 with a one-year term and an annual simple interest rate of 5%. How much interest will Alexander owe if he pays the entire loan by the end of the first year?
- Lisa’s parents invested in a bond when she was born to help pay for her education. Her parents invested $10,000 at a yearly non-compounding simple interest rate of 2.5%. What will the total amount in the account be by the time she is 18 years old? How much will her parents’ investment earn in simple interest?
- A bank is offering a savings account for new customers with an unbelievably high simple interest rate for only one year. Mo jumps on the chance and deposits $500. If the total amount in his account is $800 after the year, what interest rate did the bank offer?
- Troy owes his friend, Lee, $60 for a ticket to a rock concert they attended last semester. Lee reminds Troy that they agreed to a yearly interest rate of 4%. By the time Troy pays Lee back, he owed $1.20 in interest. How long did it take Troy to reimburse his friend?
- Safia opens a new savings account with a 2.25% non-compounding simple interest rate. She deposits $3,500. The next she checks the account, she finds she has earned $3,696.88 total. How long was the money left untouched in the savings account?
- Jacqueline took out a personal line of credit in her senior year of college with an annual simple interest rate of 4%. She takes 51 months to pay off the loan in full and pays $1,530 in interest. How much was the original line of credit amount? How much did Jacqueline pay in total?
- Mr. Jackson made a one-time deposit of $57,000 into his credit union’s retirement account when he was 25 years old. The account has a non-compounding annual simple interest rate of 3.35%. If Mr. Jackson checks this retirement account when he is 72 years old, how much will he have earned in interest? What will be the total amount in his credit union retirement account?
- Lianne’s car broke down the weekend before she started a new job. She borrowed $880 from her parents, at an annual interest rate of 3%, to quickly pay for the car repairs. If Lianne paid her parents a total of $893.20 in six months, how much simple interest did she pay?
- Rie invested her work bonus in a bond with a monthly simple interest rate of 0.8%. The bond earned her $5,016 total, of which $2,016 was interest. How many years was the money invested?
- Gabriel asked to borrow $420 from his roommate, Julian, to purchase a new laptop after his computer died. Julian agreed and told Gabriel that they could figure out an interest rate later. Gabriel paid Julian a total of $426.93 at the end of six months. What was the simple annual interest rate that Gabriel ended up paying his roommate?
Answers: 1. I = $100 2. T = $14,500 I = $4,500 3. r = 60% 4. t = 6 months 5. t = 2 years 6 months 6. P = $9,000 T = $10,530 7. I = $89,746.50 T = $146,746.50 8. I = $13.20 9. t = 7 years 10. r = 3.3%
Is Simple Interest Good or Bad?
This leads to an important question: Is the concept of simple interest good or bad? The answer? It depends.
“Simple 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 beneficial 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 may not make the most sense. 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.