Simple Interest Examples
Simple interest can be complicated. These examples explain it best.
Simple interest is one way that interest can be calculated on a loan or investment. The standard formula is I = Prt, with “p” being the principal on the loan, “r” being the rate at which interest is being charged, and “t” being the time over which interest is being charged. So principal times interest times time.
Pretty simple, right?
If you’re still confused, no need to worry—we’ve broken down real-world examples of simple interest to illustrate how it works.
Types of Simple Interest
In the financial world, simple interest can be found many places. You might encounter it when taking out a personal loan, borrowing money to buy a car, 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.
Generally, loans that use simple interest are better for the borrower than loans that use compound interest. This is because borrowers only pay interest on what they borrow—not on any interest that accrues. Loans that might feature simple interest include auto loans, installment loans, student loans, and mortgages.
A savings account is a type of bank account that pays interest. Most savings accounts use compound interest, which is better for the account holder because it pays more than simple interest. However, the returns are still relatively small, and the interest rate may actually be lower than inflation, meaning the money will devalue even though interest is being paid and technically it’s growing in amount.
This, however, doesn’t mean that there’s no place for savings accounts in healthy money management. In fact, we spoke to Todd Christensen at the credit counseling nonprofit Money Fit by DRS, Inc., about their benefits. Christensen, a financial educator, said he likes to remind his students that savings aren’t a wealth-building tool. Rather, savings accounts are “safe places to ‘park’ your money for when you need it in the near future (next couple of years),” he said.
Certificate of Deposit
A certificate of deposit (CD) is a type of bank investment that pays out an agreed-upon amount of money after a certain date. Unlike a savings account, CDs pay higher interest rates and are therefore typically a better option for longer-term investing. The tradeoff, however, is that money invested in a CD cannot be withdrawn until the maturity date without a hefty penalty.
There are two kinds of CD interest rates: simple and compound. Most CDs use compound interest, but some use simple interest.
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 percent 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 times 7 percent times 5 years, or 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 percent by one year. 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.
Certificate of Deposit
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 (simple interest) for a 24-month CD.
To determine how much he’ll make, Jose multiplies $1,500 by 5 percent 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.
Author and accredited financial counselor Todd R. Christensen, MIM, MA, is education manager at Money Fit by DRS, Inc, a nationwide nonprofit financial wellness and credit counseling agency. Todd develops educational programs and produces materials that teach personal financial skills and responsibilities to all ages. Having facilitated nearly two thousand workshops since 2004 on the fundamentals of effective money management, he based his first book, “Everyday Money for Everyday People” (2014), on the discussions, tips, stories and ideas shared by the tens of thousands of individuals and couples in attendance.
Where have you found simple interest in your financial life? Tell us on Twitter at @OppUniversity.