For example, you may pay interest on a loan, and it is important to understand how interest works. Better yet, your bank may be paying you interest on your deposits – and you can maximize your earnings by knowing more about interest.
Simple Interest Overview
Simple interest is just the amount of money paid on a loan. It is the easiest type of interest to calculate and understand. Other types of interest (like APY) can be more complex.
Simple Interest Formula
If you want to calculate simple interest, use this formula:
I=P r t
In other words Interest (I) is calculated by multiplying Principal (p) times the Rate (r) times the number of Time (t) periods.
For example, if I invest $100 (the Principal) at a 5% annual rate for 1 year the simple interest calculation is:
I=P r t
$5 = $100 x 5 % x 1 yr
Simple Interest Limitations
Simple interest is a very basic way of looking at interest. In fact, your interest – whether you’re paying it or earning it – is usually calculated using different methods. However, simple interest is a good start that gives us a general idea of what a loan will cost or what an investment will give us.
The main limitation that you should keep in mind is that simple interest does not take compounding into account.
Going Forward
Now that you know how simple interest works, you can look at more complex types of interest. Most of them are a variation of simple interest, and the calculations are repeated several times throughout the life of a loan.
A good next step is to familiarize yourself with Annual Percentage Yield (APY) which takes compounding into effect.
