Simple interest: What it is and how to calculate it
Interest can take many forms, depending on whether you’re borrowing, investing or saving. When it comes to loans, simple interest is charged only on the original amount borrowed. Lenders may use simple interest for things like personal loans, auto loans, mortgages and more.
What you’ll learn:
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Simple interest is one type of interest lenders charge to loan money, often expressed as a percentage.
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Simple interest has a fixed rate and is calculated based on the principal loan amount and the loan term.
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Personal loans, auto loans, student loans and mortgages are a few types of loans that often use simple interest.
What is simple interest?
Simple interest uses a fixed rate to determine the amount of interest owed or accumulated on a loan, investment or deposit. Unlike compound interest, simple interest is calculated based on the principal loan amount and not on any previously accumulated interest.
According to the Consumer Financial Protection Bureau (CFPB), simple interest is typically expressed as a percentage, and it may be calculated on either a daily or monthly basis.
How does simple interest work?
When it comes to loans, the amount of simple interest charged on a loan is based on:
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The principal, or original loan amount borrowed
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The loan term, or how long you have to repay the loan in full
Lenders calculate the amount of simple interest owed by looking at the borrower’s outstanding balance on the day payment is due.
How to calculate simple interest
To get the total amount of simple interest on a loan, take the principal and multiply it by the interest rate and the loan term. Here’s the simple interest formula:
Simple interest = principal x annual interest rate x loan term in years
If the loan term is less than a year, simply divide the number of months of the loan term by 12 (the number of months in a year). For example, if the loan term is six months, divide six by 12 to get 0.5, and then use 0.5 as the loan term in your calculation.
Simple interest example
Here’s how calculating simple interest might look:
$14,000 total simple interest = $40,000 (principal) x 0.06 (6% annual interest rate) x 6 (years of the loan term)
What are the benefits of simple interest?
As a borrower, you may not get to choose the type of interest you’re charged. But simple interest is a natural place to start learning about the cost of borrowing money before advancing to more complex ideas, including compound interest.
Simple interest FAQ
Here are answers to some frequently asked questions about simple interest:
What’s the difference between simple interest vs. compound interest?
The main difference between simple interest and compound interest is that simple interest is calculated using only the principal amount borrowed, invested or saved. Compound interest is calculated using both the principal and any accumulated interest.
In general, interest accumulates faster in compound interest calculations.
What’s the difference between simple interest vs. annual percentage rate (APR)?
A simple interest rate and annual percentage rate (APR) are both expressed as percentages and can give an idea of how much it costs to borrow money.
The main difference is that an APR includes additional costs or fees, including origination fees. And in the case of mortgages, APR can also include:
- Mortgage points
- Closing costs
- Mortgage broker fees
For credit cards, the APR and interest rate are typically the same.
Which types of loans use simple interest?
Borrowing terms are set by lenders, but loans that might use simple interest include:
- Mortgages
- Personal loans
- Auto loans
- Student loans
- Payday loans
Key takeaways: Simple interest
Simple interest refers to a type of interest rate that only applies to the principal amount saved, borrowed or invested. Unlike compound interest, there is no interest on top of the interest. And unlike an APR, simple interest doesn’t reflect additional fees. But when it comes to credit cards, APR and interest are usually the same.
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