INVESTING

SIMULATOR
BANKING
PERSONAL FINANCE
ECONOMY
NEWS
REVIEWS
TRADE

Table of Contents
What Is Simple Interest?
Understanding Simple Interest
Formula
Example
What Loans Use Simple Interest?
Simple vs. Compound Interest
Simple Interest FAQs
The Bottom Line
PERSONAL FINANCE BANKING
Simple Interest: Who Benefits, With Formula and Example
By ADAM HAYES Updated February 23, 2024
Reviewed by ROBERT C. KELLY
Fact checked by SUZANNE KVILHAUG
What Is Simple Interest?
Simple interest is an interest charge that borrowers pay lenders for a loan. It is
calculated using the principal only and does not include compounding interest.
Simple interest relates not just to certain loans. It's also the type of interest
that banks pay customers on their savings accounts.

The formula to determine simple interest is an easy one. Just multiply the loan's
principal amount by the annual interest rate by the term of the loan in years.

This type of interest usually applies to automobile loans or short-term loans,

although some mortgages use this calculation method.

KEY TAKEAWAYS
Simple interest is calculated by multiplying loan principal by the interest rate
and then by the term of a loan.
Simple interest can provide borrowers with a basic idea of a borrowing cost.
Auto loans and short-term personal loans are usually simple interest loans.
Simple interest involves no calculation of compound interest.
A benefit of simple interest over compound interest can be a lower borrowing cost.
Simple Interest
Investopedia / Nez Riaz

Understanding Simple Interest

Interest is the cost of borrowing money. Typically expressed as a percentage, it
amounts to a fee or charge that the borrower pays the lender for the financed sum.
Simple interest is an easy way to look at the charge you'll pay for borrowing. The
interest rate is calculated against the principal amount and that amount never
changes, as long as you make payments on time. Neither compounding interest nor
calculation of the interest rate against a growing total balance is involved.

That means you'll always pay less interest with a simple interest loan than a
compound interest loan if the loan term is greater than one year.
Many debt transactions involve a more complex calculation of interest than simple
interest.
Benefits of a Simple Interest Loan
Interest doesn't compound or get added to the principal amount for a larger
borrowing cost result. You never pay interest on interest.
Borrowers can save money.
Debts can be easier to pay off.
The simple interest calculation is simple and straightforward.
Simple interest is better for borrowers because it doesn't account for compound
interest. On the other hand, compound interest is a key to building wealth for
investors.

Simple Interest Formula

The formula for simple interest is straightforward:

Simple Interest
=
𝑃
×
𝑟
×
𝑛
where:
𝑃
=
Principal
𝑟
=
Interest rate
𝑛
=
Term of loan, in years

Simple Interest=P×r×n
where:
P=Principal
r=Interest rate
n=Term of loan, in years

Example of Simple Interest

As a reminder, simple interest paid or received over a certain period is a fixed
percentage of the principal amount that was borrowed or lent.

For example, let's say that a student obtains a simple interest loan to pay for one
year of college tuition. The loan amount is $18,000. The annual interest rate on
the loan is 6%. The term of the loan is three years.

Using the simple interest formula above, the amount of simple interest on the
student's loan is:

$
1
8
,
0
0
0
×
0
.
0
6
×
3
=
$
3
,
2
4
0
$18,000×0.06×3=$3,240

Therefore, the total amount of principal and interest paid to the lender is:

$
1
8
,
0
0
0
+
$
3
,
2
4
0
=
$
2
1
,
2
4
0
$18,000+$3,240=$21,240

Simple Interest vs. Daily Simple Interest

Simple Interest is similar to Daily Simple Interest except that with the latter,
interest accrues daily and is added to your account balance. Also, while loan
balances on simple interest debt are reduced on the payment due date, daily simple
interest loan balances are reduced on the day payments are received.
1

What Types of Loans Use Simple Interest?

Simple interest usually applies to automobile loans or short-term personal loans.
In the U.S., most mortgages on an amortization schedule also involve simple
interest, although they can certainly feel like compound interest loans.

The compounding feel comes from varying principal payments—that is, the percentage
of your mortgage payment that's actually going towards the loan itself, not the
interest.

The interest doesn’t compound. Rather, the principal payments do. A $1,000
principal payment saves interest on that $1,000 and results in higher principal
payments the next year, and higher the following year, and so on.

If you don’t let the principal payments vary, as in an interest-only loan (zero
principal payment), or by equalizing the principal payments, the loan interest
itself doesn’t compound. If you make partial payments to a simple interest loan,
the payment will be applied to interest first, and any remainder will be used to
reduce the principal.

Lowering the interest rate, shortening the loan term, or prepaying principal also
has a compounding effect.

For example, take bi-weekly mortgage payment plans. Biweekly plans generally help
consumers pay off their mortgages early because the borrowers make two extra
payments a year, saving interest over the life of the loan by paying off the
principal faster.

For a short-term personal loan, a personal loan calculator can be a great way to
determine in advance an interest rate that's within your means. For longer-term
loans, this calculator may also be of help.
Simple Interest vs. Compound Interest
Interest can be either simple or compounded. Simple interest is based on the
original principal amount of a loan or deposit.

Compound interest, on the other hand, is based on the principal amount and the
interest that accumulates on it in every period. The more frequently interest is
compounded—quarterly, monthly, or even daily—the greater the total amount of
payments in the long run.

Since simple interest is calculated only on the principal, it is easier to

determine than compound interest.

Compound interest is often a factor in business transactions, investments, and

financial products intended to extend for multiple periods or years. Typically,
simple interest is used for loans of a single period or less than a year.

The formula to determine compound interest involves the same variables as simple
interest and is:

𝑃
×
(
1
+
𝑟
)
𝑛
−
𝑃

P×(1+r)
n
−P
Borrowing Cost With Simple Interest
Let's say that you are borrowing $10,000 from Bank A to finance an automobile
purchase. It's a simple interest loan with a rate of 5% and a term of 5 years.

The amount of interest that you'll owe is:

$
1
0
,
0
0
0
×
.
0
5
×
5
=
$
2
,
5
0
0
$10,000×.05×5=$2,500

The total amount that you'll pay the lender will be:

$
1
0
,
0
0
0
+
$
2
,
5
0
0
=
$
1
2
,
5
0
0
$10,000+$2,500=$12,500
Borrowing Cost With Compound Interest
This time, you take out a compound interest loan from Bank A. The essential terms
are the same: a $10,000 loan, 5% interest rate, and term of five years.

In this case, the amount of interest that you'll owe is:

$
1
0
,
0
0
0
×
(
1
+
.
0
5
)
5
−
$
1
0
,
0
0
0
=
$
2
,
7
6
2
.
8
2
$10,000×(1+.05)
5
−$10,000=$2,762.82

The total amount that you'll pay the lender will be $12,762.82.

If you'd like to calculate a total value for principal and interest that will
accrue over a particular period of time, use this slightly more involved simple
interest formula: A = P(1 + rt). A = total accrued, P = the principal amount of
money (e.g., to be invested), r = interest rate per period, t = number of periods.

Why Is Simple Interest "Simple"?

"Simple" interest refers to the straightforward crediting of cash flows associated
with some investment or deposit. For instance, 1% annual simple interest would
credit $1 for every $100 invested, year after year. Simple interest does not,
however, take into account the power of compounding, or interest-on-interest, where
after the first year the 1% would actually be earned on the $101 balance—adding up
to $1.01. The next year, the 1% would be earned on $102.01, amounting to $1.02. And
so one.

Which Will Pay Out More Over Time, Simple or Compound Interest?
Compound interest will always pay more after the first payment period. Suppose you
borrow $10,000 at a 10% annual interest rate with the principal and interest due as
a lump sum in three years. Using a simple interest calculation, 10% of the
principal balance gets added to your repayment amount during each of the three
years. That comes out to $1,000 per year, which totals $3,000 in interest over the
life of the loan.

At repayment, then, the amount due is $13,000. Now suppose you take out the same
loan, with the same terms, but the interest is compounded annually. When the loan
is due, instead of owing $13,000, you end up owing $13,310. While you may not
consider $310 a huge difference, this example is only a three-year loan; compound
interest piles up and becomes oppressive with longer loan terms.

What Are Some Financial Instruments That Use Simple Interest?

Most coupon-paying bonds utilize simple interest. So do most personal loans,
including student loans and auto loans, and home mortgages.

What Are Some Financial Instruments That Use Compound Interest?

Most bank deposit accounts, credit cards, and some lines of credit will tend to use
compound interest.

The Bottom Line

Simple interest is the interest charge on borrowing that's calculated using an
original principal amount only and an interest rate that never changes. It does not
involve compounding, where borrowers end up paying interest on principal and
interest that grows over multiple payment periods.

Simple interest can be advantageous for borrowers because of its relatively lower
cost of money. However, bear in mind that, because of its simple calculation, it
gives only a basic idea of cost that may not account for other charges/fees that a
loan may include.

ARTICLE SOURCES
Related Terms
Cumulative Interest Definition, Formulas and Uses
Cumulative interest is the sum of all interest payments made on a loan over a
certain time period. more
What Is APY and How Is It Calculated?
The annual percentage yield (APY) is the effective rate of return on an investment
for one year taking compounding interest into account. more
The Power of Compound Interest: Calculations and Examples
Compound interest is interest that applies not only to the initial principal of an
investment or a loan, but also to the accumulated interest from previous periods.
more
Annual Percentage Rate (APR): What It Means and How It Works
Annual Percentage Rate (APR) is the interest charged for borrowing that represents
the actual yearly cost of the loan, including fees, expressed as a percentage. more
Principal: Definition in Loans, Bonds, Investments, and Transactions
Principal is money that's lent to a borrower or placed into an investment. It can
also refer to a private company’s owner or the chief participant in a deal. more
Forward Rate Agreement (FRA): Definition, Formulas, and Example
Forward rate agreements are over-the-counter contracts between parties that
determine the rate of interest to be paid on an agreed-upon date in the future.
more
Related Articles
Girl with calculator and papers at desk
Simple Interest vs. Compound Interest: What's the Difference?

Cumulative Interest Definition, Formulas and Uses

Annual Percentage Yield (APY)
What Is APY and How Is It Calculated?
Compound Interest
The Power of Compound Interest: Calculations and Examples
Businessmen
Annual Percentage Rate (APR): What It Means and How It Works
APR vs. APY
APR vs. APY: What’s the Difference?
Partner Links
TRUSTe
About Us
Terms of Service
Dictionary
Editorial Policy
Advertise
News
Privacy Policy
Contact Us
Careers
#
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
X
Y
Z
Investopedia is part of the Dotdash Meredith publishing family.