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. Interest can affect you in various aspects of your financial life:
When borrowing money: You must repay the amount you borrowed and include payments for interest, which represents the cost of borrowing. When lending money: Lenders typically set a rate and earn interest income in exchange for making money available to other people. When depositing money: Interest-bearing accounts, such as savings accounts, pay interest income because you are making your money available to the bank to lend to others.
Simple Interest Formula
To calculate simple interest, multiply the principal amount by the interest rate and the time. The formula written out is “Simple Interest = Principal x Interest Rate x Time.” This equation is the simplest way of calculating interest. Once you understand how to calculate simple interest, you can move on to other calculations, such as annual percentage yield (APY), annual percentage rate (APR), and compound interest.
Example of Simple Interest
For example, say you invest $100 (the principal) at a 5% annual rate for one year. The simple interest calculation is:
$100 x .05 interest x 1 year = $5 simple interest earned after one year
Note that the interest rate (5%) appears as a decimal (.05). To do your own calculations, you will need to convert percentages to decimals. For example, to convert 5% into a decimal, divide five by 100 to get .05. If you want to calculate simple interest over more than one year, calculate the interest earnings using the principal from the first year, multiplied by the interest rate and the total number of years.
$100 x .05 interest rate x 3 years = $15 simple interest for three years
Simple Interest vs. Compound Interest
When you start accounting for compounding, you need to use more complex interest calculations that measure “compounding frequency,” or how often the interest is compounded. This could be daily, monthly, yearly, or some other frequency. Each frequency would give different results. For example, when you borrow funds with a credit card, you might estimate how much interest you pay using simple interest. However, most credit cards quote an annual percentage rate (APR) to customers, but they actually charge interest daily, and each day’s total of principal and interest becomes the basis for the next interest charge. As a result, you accumulate a lot more in interest charges than you would tally with a simple interest calculation.
Limitations of Simple Interest
The simple interest calculation provides a very basic way of looking at interest. It’s an introduction to the concept of interest in general. In the real world, your interest—whether you’re paying it or earning it—is usually calculated using more complex methods. There may also be other costs factored into a loan than just interest. These costs will affect the total amount that you spend on the loan throughout the year, but they may not be included in the interest rate given to you by the lender.
