What Is Simple Interest?
Simple interest is a method of calculating interest where the charge is always based on the original principal amount. Unlike compound interest, simple interest does not take into account previously earned interest. This makes it straightforward to calculate and easy to predict. Simple interest is commonly used for short-term loans, car loans, and some types of bonds.
The Simple Interest Formula
Where:
I = Interest earned or owed
P = Principal (original amount)
r = Annual interest rate (as a decimal)
t = Time in years
Step-by-Step Example
You borrow $3,000 at 5% simple interest for 4 years:
- Identify values: P = $3,000, r = 0.05, t = 4
- Plug into formula: I = $3,000 × 0.05 × 4
- Calculate: I = $600
- Total repayment: $3,000 + $600 = $3,600
Finding Different Variables
You can rearrange the formula to solve for any variable:
Rate: r = I ÷ (P × t)
Time: t = I ÷ (P × r)
Example: Finding the Rate
You earned $240 in interest on a $2,000 deposit over 3 years. What was the rate?
r = $240 ÷ ($2,000 × 3) = $240 ÷ $6,000 = 0.04 = 4%
When Is Simple Interest Used?
| Application | Typical Use | Why Simple Interest |
|---|---|---|
| Car loans | Auto financing | Fixed payment schedule |
| Short-term personal loans | 1-3 year loans | Straightforward cost |
| Treasury bills | Government bonds | Short maturity periods |
| Store financing | Buy-now-pay-later | Promotional clarity |
| Student loan interest | During grace period | Regulated by law |
Simple Interest vs Compound Interest
Here is how $5,000 grows at 6% over different periods under each method:
| Years | Simple Interest | Compound Interest (Annual) | Extra from Compounding |
|---|---|---|---|
| 1 | $5,300 | $5,300 | $0 |
| 5 | $6,500 | $6,691 | $191 |
| 10 | $8,000 | $8,954 | $954 |
| 20 | $11,000 | $16,036 | $5,036 |
For short time periods (1-2 years), simple and compound interest are nearly identical. The difference grows significantly over longer periods.
Calculating Monthly Simple Interest
When time is given in months rather than years, convert first:
Example: $1,000 at 8% for 9 months: I = $1,000 × 0.08 × (9/12) = $1,000 × 0.08 × 0.75 = $60
Key Takeaways
- Simple interest is always calculated on the original principal only.
- It is best suited for short-term loans and fixed-duration borrowing.
- The formula is easy to use: just multiply principal × rate × time.
- For long-term investments, compound interest will always yield more.
- Always check whether a financial product uses simple or compound interest before signing.
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