When you’re figuring out which type of personal loan to take out, simple interest is something to keep in mind and consider. What is simple interest and why does it factor into your decision? We’ll explain everything you need to know about simple interest.
What is simple interest?
Simple interest is the cost that borrowers pay lenders for a loan. This type of interest is calculated using only the principal, which is the amount of your loan that has not yet been paid. Most importantly, simple interest does not compound, or continue to add up. A common example of a simple interest loan is a mortgage loan; with most mortgage loans, you only pay interest on the balance of the loan. Simple interest is also the type of interest that banks pay customers on their savings accounts.
How does simple interest work?
As we mentioned, a simple interest loan charges interest only on the principal. With a simple interest loan, simple interest is calculated by multiplying the loan’s current principal amount by the interest rate. However, here’s where a simple interest loan differs from a loan with compounding interest–every time you pay down the principal with your monthly payment, your principal decreases; this also lowers the interest assessed. The more you pay on your principal (if you pay more than the minimum payment, for example), the more the principal goes down.
Let’s look at an example of how simple interest works. You take out a $2,000 simple-interest loan with a 6% fixed interest rate, with the loan to be paid off within five years. Instead of paying 6% interest on the entire $2,000 principal (as you would with a compound interest loan), you pay 6% interest on the new balance of your loan each month as you pay it down. Simple interest is assessed each month against the current balance–not the original balance. So, if you pay $200 as your first payment on the simple interest loan, the following month’s interest will be 6% of $1,800, your new outstanding principal.
What is the formula for simple interest?
The formula to calculate simple interest is actually pretty, well, simple!
Simple Interest = P × r × n
P = Principal
r = Interest rate
n = Term of loan, in years
With this formula in mind, let’s look at our previous example again to determine the amount of interest as well as the principal plus interest that will be paid to the lender.
In this case, P = $2,000, r = 6% (which is 0.06 for mathematical purposes), and n = 5.
$2,000 x 0.06 x 5 = $600 in simple interest. Your total payment of principal plus interest on the loan to the lender is $2,600.
This is useful information to have. Knowing how much interest you will pay on the life of the loan can help you decide which type of loan is right for you when you need to borrow money. It’s important to keep in mind, however, that simple interest loans may not even be an option in your state. If not, this formula will not apply to your loan. Be sure to ask potential lenders about the type of loan options they offer.
What is the difference between simple interest and compound interest?
We already know that simple interest is based on the principal amount of a loan or a deposit into your savings account. Compound interest, however, is calculated based on the principal amount plus the interest that is charged to the loan every period–whether that period is monthly, daily, or quarterly. The more frequently the interest is compounded, the higher the total amount of payments you’ll make during the course of the loan.
The easy way to look at compound interest is that, unlike a simple interest loan, you’re paying interest on interest.
According to Investopedia, “compound interest is often a factor in business transactions, investments, and financial products intended to extend for multiple periods of years. Typically, simple interest is used for loans of a single period or less than a year.”
As a quick example of the difference between what you might pay with a simple interest loan vs. a compound interest loan, we’ll use the same numbers from above but plugged into the compound interest formula, which is: A = P(1 + r/n)nt.
A = Future amount
P = Initial principal balance
r = Interest rate
n = Number of times compounded
t = Number of years for loan or deposit
In our scenario from earlier, the formula to calculate the total with interest compounding monthly will look like A = $2,000(1 + 0.06/12)12×5.
- A = $2,000(1 + 0.06/12)12*5
- A = $2,000(1 + 0.06/12)60
- A = $2,000(1.005)60
- A = $2,000 x 1.34885015255
- A = $2,697.70
Now, when we compare the totals of the simple interest loan and the compound interest loan, you’ll see that for a $2,000 loan with 6% interest over a five-year term costs $97 less with the simple interest loan. Of course, $97 may not seem like a large amount of money, but keep in mind: Many loans will exceed $2,000, which means the interest totals will increase as well. And that means the difference between a simple interest loan and compound interest loan will grow as well.
