What Is Simple Interest?

Interest is the fee paid on an amount of money, whether borrowed, borrowed, or invested. Simple interest is a specific type of interest calculation that does not take composition into account.

Matching is the repetitive process of earning (or charging) interest, adding that amount of interest to the principal balance, and then earning even more interest in the next period due to the increase in the account balance.

Read on to learn how to calculate simple interest and why this calculation is sometimes not an accurate representation of your interest charges.

Definition and examples of simple interest

Interest represents a fee you pay on a loan or the income you earn from deposits. Simple interest is a specific way of measuring interest that does not take into account multiple interest payment periods or charges. In other words, the interest rate will only apply to the principal amount of the loan or investment; you will not be affected by any accrued interest.

Interest can affect you in several aspects of your financial life:

  • When borrowing money: You must repay the loan amount and make additional interest payments, which represent the cost of the loan.
  • When borrowing money: You usually set a fee and receive interest in exchange for making your money available to others.
  • By depositing money: Interest-bearing accounts, such as savings accounts, pay interest income because you make your money available to the bank for lending to others.

How is simple interest calculated?

This equation is the easiest way to calculate 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.

To calculate simple interest, multiply the principal amount by the interest rate and by time.

Using calculators

If you don't want to do these calculations yourself, you can use a calculator or let Google do the calculations for you. In Google, just type the formula in a search box, click go back, and you will see the results. For example, a search for "5/100" will do the same for you (the result should be 0.05).

For a simple and comprehensive interest calculation, use this spreadsheet template in Google Sheets.

How Simple Interest Works

Understanding simple interest is one of the most fundamental concepts in managing your finances. It's simple math, but calculators can do the work for you if you prefer. By understanding how interest rates work, you are empowered to make better financial decisions that will save you money.

For example, let's say you invest $ 100 (the principal) at a 5% annual rate for one year. The simple interest calculation is:

$ 100 x 0.05 interest x 1 year = $ 5 simple interest earned after one year
Note that the interest rate (5%) appears as a decimal (0.05). To do your own calculations, you will need to convert the percentages to decimals. For example, to convert 5% to a decimal, divide five by 100 to get 0.05.

An easy trick to remember is to think of the word percentage as "per 100". You can convert a percentage to decimal form by dividing it by 100. Or simply move the decimal point two spaces to the left.

If you want to calculate the simple interest for 1 year, calculate the interest income using the principal of the first year, multiplied by the interest rate and the total number of years.

$ 100 x 0.05 interest rate x 3 years = $ 15 simple interest for three years

Limitations of Simple Interest

The simple interest calculation provides a very basic way of looking at interest. It is an introduction to the concept of interest in general. In the real world, your interest, whether you are paying or earning, is often calculated using more complex methods.

There may also be other costs charged to a loan in addition to interest. These costs will affect the total amount you spend on the loan over the course of the year, but may not be included in the interest rate provided by the lender.

For loans like 30-year mortgages, for example, simple interest calculations aren't a completely accurate way to calculate your costs, as they don't factor in closing costs, which can affect your APR.

The effects of compounding become more pronounced over time, which is another reason why a 30-year mortgage is not a good candidate for simple interest calculations. Over the 30-year life of the loan, interest costs will significantly increase the total cost paid by the borrower.

As you begin to account for compound interest, you should use more complex interest calculations that measure "compounding frequency," or how often interest is compounded. This can 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 can estimate how much interest you pay using simple interest.

However, most credit cards offer customers an annual percentage rate (APR), but they actually charge interest on a daily basis, with the principal and total interest for each day becoming the basis for the next charge.

As a result, you accumulate far more interest expenses than you would accumulate with a simple interest calculation.

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Source: Don't Memorise

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