Understanding simple interest is an important step in mastering your finances.there may be a little bit of math involved, but it's not complex math, and you can always have a calculator do the work for you if you like. Once you understand have interest works,you'll be in a better position to make smart decisions.
Simple Interest Overview
Simple interest is money that you pay on a loan, or that you earn on deposits. For example, when you borrow money, you have to repay the loan along with a little extra. Or, when you deposit money in a savings account, you earn money on that deposit (and you can take your original deposit out along with your interest earnings). Interest is that additional money, and the amount of interest is calculated based on the original sum of money (called the "principal").
The term "simple" means you're working with the simplest way of calculating interest. Once you understand how to calculate simple interest, you can move on to other varieties (like APY, APR, and compound interest).
Simple Interest Formula
To calculate simple interest, use this formula:
I = P x r x t
Explanation: Simple Interest (I) is calculated by multiplying Principal (p) times the Rate (r) times the number of Time (t) periods.
Example: You invest $100 (the Principal) at a 5% annual rate for 1 year. The simple interest calculation is:
P x r x t = I
$100 x 5% x 1 year = $5
$100 x .05 x 1 year = $5
Note that the interest rate (5%) is written as a decimal (.05). To do your own calculations, you'll need to convert percentages to decimals. An easy way to remember how is to think of the word "percent" as "per 100." Then, you can convert a percentage into its decimal form by dividing by 100. For example:
5 divided by 100 = .05
Note that it is not 5% divided by 100, it's simply 5, so:
5 / 100 = .05
You can also just move the decimal two places to the left so that 5.00 becomes 0.05.
Calculators: if you don't want to do these calculations yourself, you can use a calculator, spreadsheet, or have Google perform calculations for you. Just type the formula into a search box, hit return, and you'll see the results. For example, try the phrase "5 / 100" (you should get an answer of .05). This link will perform that same function for you.
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 and it can give you a general idea of what a loan will cost or what an investment will return.
As the time period involved gets longer (if you're dealing with a 30 year mortgage instead of a one year bank deposit, for example), simple interest calculations become less accurate. The same is true of "compounding frequency." For example, when you borrow with a credit card, you might estimate how much interest you pay using simple interest. However, most credit cards quote an annual percentage rate (APR), but interest is charged daily. As a result, you'll owe a lot more than you imagined if you use a simple interest calculation.
The main thing to keep in mind is that simple interest does not take compounding into account.
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.
You can also see how much interest you pay when borrowing money. Running the numbers may motivate you to borrow less and repay debt more quickly.