Takeaways
- Simple interest is the principal balance multiplied by your interest rate and term.
- Financial products like personal loans, car loans, and mortgages use simple interest.
- Simple interest always pays less interest income than compounding interest products.
- Simple interest does not consider compounding periods for total interest.
- Borrowers prefer simple interest, and savers prefer compounding interest products.
Over the last several years, consumer debt has been one of the fastest categories of household spending. Chances are you are already very familiar with various credit products like installment loans, credit cards, and car loans.
For the newer borrower, it is critical to understand the key components of credit products, including how interest works, so that you can choose the best one for you. While every savings or credit product has its unique structure, terms, and fees, interest is a constant variable because it determines how much interest expense or income is generated.
Understanding how interest works, the different kinds, and how it impacts your total cost of borrowing will help you manage your money better. Here, we examine how simple interest works.
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What is Simple Interest?
When considering taking out new debt or investing in a savings product, it is vital to understand the type of interest used and how it is calculated. There are two types of interest to know: compounding and simple interest.
Simple interest is the amount of interest that a borrower pays on a loan without considering compounding periods.
Simple interest is a relatively straightforward calculation that uses only the loan's principal, the agreed-upon interest rate, and the loan term (in years). It does not consider any compounding periods during the loan.
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Simple Interest Calculation
Simple interest keeps the total costs of interest paid over the life of the loan lower than a similar offering using compounding interest. Here’s how to calculate simple interest:
Simple Interest Formula
Simple Interest = P*R*T
P – Principal balance of the loan
R – Annual interest rate
T – Loan term in years
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Simple Interest Calculator
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3 Products That Use Simple Interest
Simple interest is used in many loans and credit products offered by banks, credit unions, and other financial institutions. Here are three products that use simple interest:
- Personal Loans: Short-term personal loan lenders often use simple interest. These loans have terms of only a couple of months and have principals of $1,000 or less. Lenders sometimes don’t charge a percentage but a fee for a specific dollar amount borrowed. (Read about how payday loans work).
- Car Loans: Simple-interest car loans are a standard way to finance new or used car purchases. They offer you a fixed interest rate, principal, and term. Simple interest car loans have a fixed monthly payment that includes a portion of interest and principal.
- Home Mortgages: Whether you are getting a 30-year fixed-rate mortgage or a 15-year fixed-rate mortgage, chances are you are securing a simple interest mortgage. Mortgage amortization tables break down how much of your monthly mortgage goes to your interest and principal year month.
Simple Interest Example
Here is a real-world example: Despite the rising prices of new vehicles, you decide it’s time to buy a car to consistently get to work on time. After all, you have been working on getting a promotion.
While you are shopping for a new car, you find the perfect one, which costs $30,000. The car dealership agrees to give you a simple interest loan for the full asking price, with a 5% interest rate and a 5-year term. There is no down payment required.
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Here’s how you would calculate the total interest paid over the life of the loan:
Total Simple Interest = $30,000 X 5% X 5 yrs.
Total Simple Interest = $7,500
Annualized Simple Interest = $7,500/5 yrs.
Annualized Simple Interest = $1,500
Your total loan cost will be $30,000 in principal plus $7,500 in total simple interest, for a total of $37,500.
You can calculate your monthly expenses now that you know your total and annual interest payments. Knowing your monthly payments provides the insight you need to determine car affordability and map these payments into your monthly budget.
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All you need to do is divide the total amount of the loan (principal plus interest) by the total number of months of the loan.
In this example, the loan is five years or 60 months. As a result, your monthly payment will be $625 ($37,500/60). This monthly payment of $625 consists of a fixed interest payment of $125 ($7,500/60) plus monthly principal payments of $500 ($30,500/60). Now, you can determine whether your monthly budget can handle these payments.
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Simple Interest vs. Compound Interest
- Simple Interest is only calculated on your principal, interest rate, and loan term. It does not take into account any sort of compounding.
As a result, simple interest is much more favorable to borrowers because you pay less interest over the life of the loan. If your loan compounded during your loan term, you would end up paying much more interest expense.
- Compound Interest is calculated based on your principal amount and accumulating interest. Compound interest not only considers your principal and interest but also the number of accumulating periods when interest is calculated. The greater the number of compounding periods - month, quarter, or year- the faster your interest payments will grow.
Compounding interest is always more expensive than simple interest for borrowers because interest payments continue to grow. Conversely, this is why compounding interest is better for savers.
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Smart Summary
Simple interest is a financial term that describes the amount of interest paid on a note without taking compounding interest into account. Many financial products, such as installment loans, car notes, and mortgages, use simple interest. Borrowers much prefer credit products with simple interest because it reduces the interest expense over the life of a loan. Savers, however, prefer compounding interest because it quickly compounds the interest income they earn.
(1) Last Accessed January 13, 2025.
