What Is Simple Interest? How to Calculate Simple Interest

Simple interest refers to an interest rate solely based on the original principal balance of an investment or loan. Simple interest loans feature a set amount of payments of equal value spread out over a contractually agreed-upon time frame. When borrowing money from a lender, simple interest calculations add up to a smaller overall payment in the long run, rewarding borrowers who pay on time or early each period. Simple interest loans include auto loans, most federal student loans, and short-term personal finance loans. (Though, there are some simple interest mortgage options with rates calculated daily rather than monthly.)

Simple interest contrasts with compound interest, which is interest earned from the original principal amount of a deposit or investment, plus any accumulated interest from prior earning periods. Compound interest factors in both the principal loan amount and the accrued interest in a process called compounding, making for a more complex formula and a larger overall figure for borrowers to repay. Mortgages are one of the most common loans with compound interest.

To calculate simple interest, use the following formula:

Simple interest = P x R x T

In this formula, P is the principal loan balance, R is the interest rate (in decimal form), and T is the period of time.

Here’s a quick step-by-step guide on how to use the simple interest formula to calculate the amount of interest for a simple interest loan:

1. 1. Determine your principal amount. The largest figure in the simple interest formula is P, or the principal amount of the loan—for instance, a car loan with an original principal of $10,000.
2. 2. Convert your interest rate to a decimal. Use a decimal format rather than a percentage to calculate a simple interest payment. If the rate of interest is 5 percent annually, then the decimal expression is .05.
3. 3. Ensure your interest rate and time frame are compatible. For the formula to work properly, your interest rate and time frame must use the same unit of measurement—for instance, if the interest rate is an annual percentage rate, break your time frame down into the number of years (e.g., three years) rather than months.
4. 4. Multiply the three variables. After preparing your variables, multiply them together. For example, to calculate the total interest payment of a $10,000 loan with a 5 percent annual interest rate over three years, multiply 10,000 by .05 by 3, for a total amount of $1,500.

Simple interest and compound interest are two types of interest that differ in several areas:

• Variables: Lenders base simple interest solely on the principal of a loan, whereas compound interest factors in both the principal and previously accumulated interest.
• Order of payment: Lenders first apply simple interest loan payments toward any outstanding interest, and any remainder goes toward the principal. By contrast, compound interest loans incorporate a portion of the interest back into the loan so that borrowers end up paying interest on their interest.
• Application: Different types of loans use different types of interest calculations. Loans that use the simple interest formula are typically short-term loans like car loans, quick personal loans, and certain mortgages. Conversely, loans that use the compound interest formula are typically long-term payments like business transactions, credit card payments, and investments. In addition, financial institutions typically use the compound interest model for bank accounts such as deposit and savings accounts.

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