Simple Interest: Definition, Formula, Examples and FAQs

The interest doesn’t compound or increase with time; it’s a fixed amount each year based on the initial $\$1,000$ borrowed. Understanding simple interest is one of the most fundamental concepts for mastering your finances. It involves some simple math, but calculators can do the work for you if you prefer. With an understanding of how interest works, you become empowered to make better financial decisions that save you money.

  1. Suppose you invest $3000 into an account that pays you 7% interest per year for four years.
  2. For a short-term personal loan, a personal loan calculator can be a great way to determine in advance an interest rate that’s within your means.
  3. Simple Interest is the interest paid on the principal amount for which the interest earned regularly is not added to the principal amount as we do in compound interest.
  4. Investment is when you put money where it can grow, such as a bank, or a business.

It will make your money grow faster in the case of invested assets. However, on a loan, compound interest can create a snowball effect and exponentially increase your debt. If you have a loan, you’ll pay less over time with simple interest.

Discounts on Early Payments

To calculate simple interest monthly, we have to divide the yearly interest calculated by 12. So, the formula for calculating monthly simple interest becomes (P × R × T) / (100 × 12). Rishav takes a loan of Rs from a bank for a period of 1 year. Find the interest and the amount he has to pay at the end of a year. As a reminder, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent.

Simple Interest Calculator

The discount factor can be thought of as the reciprocal of the interest rate and is the factor by which a future value must be multiplied to get the present value. With simple interest, we were assuming that we pocketed the interest when we received it. In a standard bank account, any interest we earn is automatically added to our balance, and we earn bench bookkeeping review interest on that interest in future years. We looked at this situation earlier, in the chapter on exponential growth. If you are investing, though, compound interest combines the initial amount loaned with the interest that’s been accumulated from previous periods. Essentially, your interest earns interest on itself, meaning it snowballs over time.

As established above, a loan this size would total $12,500 after five years. That’s $10,000 on the original principal plus $2,500 in interest payments. The higher the number of compounding periods, the larger the effect of compounding. Compounding can work in your favor when it comes to your investments, but it can also work for you when making loan repayments. Interest payable at the end of each year is shown in the table below.

With the basic knowledge on how the concepts work, you get empowered to make good financial decisions. In this article, we are going to learn how to calculate simple interest and the knowledge to solve real life problems. Let’s first start by defining the terms involved in simple interest. Have you ever lent or borrowed money from your friend or relative?

Simple vs. Compound Interest: Definition and Formulas

In this case, we’re going to have to set up the equation, and solve for \(P\). Investing early is important for investors because the benefits of compound interest accumulate over time. In this case, we’re going to have to set up the equation, and solve for P. Compound interest is interest paid both on the original principal and on all interest that has been added to the original principal. Each week, our tutors support thousands of students who are at risk of not meeting their grade-level expectations, and help accelerate their progress and boost their confidence.

Simple interest is an easy way to look at the charge you’ll pay for borrowing. The interest rate is calculated against the principal amount and that amount never changes, as long as you make payments on time. Neither compounding interest nor calculation of the interest rate against a growing total balance is involved. Most coupon-paying bonds, personal loans, and home mortgages use simple interest. On the other hand, most bank deposit accounts, credit cards, and some lines of credit tend to use compound interest.

Understanding Simple Interest

Compounding can work against you if you carry loans with very high rates of interest, like credit card or department store debt. For example, a credit card balance of $25,000 carried at an interest rate of 20%—compounded monthly—would result in a total interest charge of $5,485 over one year or $457 per month. Department stores often offer major appliances on a simple-interest basis for periods of up to one year. So, suppose you buy a refrigerator for $2,000 and pay simple interest at an annual rate of 8%. Simple interest is the cost of using or borrowing money without compound interest or interest on interest.

Percents Check for Understanding Quiz (Grade 6 to

Accounts with this structure earn you monthly interest in exchange for making your money available for the bank to lend out. Simple interest is interest earned only on the initial amount invested, also known as the principal balance. Car loans or auto loans use simple interest to calculate the interest. The borrower agrees to pay the money back, plus a flat percentage of the amount borrowed. But in case the borrower fails to repay the amount on time, the company or the lender may start charging compound interest. To find the simple interest calculator (SI calculator), click here.

Make sure you know the exact annual percentage rate (APR) on your loan since the method of calculation and number of compounding periods can have an impact on your monthly payments. While banks and financial institutions have standardized methods to calculate interest payable on mortgages and other loans, the calculations may differ slightly from one country to the next. In this article, we learned about the concept of simple interest and how it is calculated using the principal amount, interest rate, and time period. Simple interest provides a straightforward method to determine the interest accrued on a loan or investment. To reinforce our understanding, let’s now apply the simple interest formula through solving examples and attempting MCQs for better comprehension.

Cumulative interest can also help you choose one bond investment over another. As you can see, over a long period of time, compounding makes a large difference in the account balance. You may recognize this as the difference between linear growth and exponential growth.

Simple interest is a method of interest that always applies to the original principal amount, with the same rate of interest for every time cycle. When we invest our money in any bank, the bank provides us interest on our amount. The interest applied by the banks is of many types and one of them is simple interest. Now, before going deeper into the concept of simple interest, let’s first understand what is the meaning of a loan. Let’s see one simple example to understand the concept of simple interest.