At some point in our lives, most of us will borrow money from a lender. This might be in the form of a home mortgage, an auto loan, student loans, or even a home equity line of credit, but no matter the type of debt, we will almost always pay interest on that debt.
Calculating exactly how much interest you’ll pay on a debt can be tricky, though, especially when you learn that there are different types of formulas. The most basic of these is called simple interest and, as the name implies, is pretty simple to both understand and calculate.
Simple Interest Definition
In the most basic terms, simple interest is the calculation showing how much will be paid in total interest on funds borrowed over a specific period of time.
Simple interest can be calculated on money that you borrow, money that you lend, and even funds that you deposit in an interest-bearing account. The actual calculations for each, though, will differ slightly. Today, we’re going to focus on simple interest on debt.
Other Important Terms
Before we get into calculating simple interest, you’ll need to understand a few basic loan terms.
When you borrow money – whether that’s in the form of a financed car or a personal loan deposited into your checking account – your initial debt amount is called the principal. If you take out a $10,000 loan or buy a $10,000 car, your principal balance is an easy $10,000.
You’ll then need to know the loan period for your new account, which is how long you have to pay off the debt.
Installment accounts are loans that are given one time and then paid off each month until the balance reaches 0, according to the agreed loan terms. This is different from a revolving account, such as a credit card, where you can continue to add to the balance and don’t have a set time frame for total repayment.
Then, you’ll need to know how much you’ll be charged for the debt. This is referred to as the APR, or annual percentage rate, and determines how much the lender will charge you each year in exchange for letting you borrow money.
A loan’s APR is not the same as its interest rate, however. To figure that out – and calculate the total simple interest you’ll be charged – you’ll need to do a bit of math.
How To Calculate: Simple Interest Formula
As you can probably guess, calculating simple interest is pretty easy. In fact, you probably learned how to do it in high school, though many of us forgot this important financial lesson long before we ever signed on our first loan.
The formula for simple interest is: Simple Interest = (principal) x (rate) x (# of periods).
Principal is the amount you borrowed, the rate represents the interest rate you agreed to, and the number of periods refers to the length of time in question.
Here’s an example: you borrow $10,000 at 4.0% interest for 4 years. In your first year, you’ll be paying $400 in simple interest on that loan:
$10,000 (principal) x 0.04 (rate) x 1 (number of years) = $400
Over the four-year life of that loan, however, you will pay $1,600:
$10,000 x 0.04 x 4 = $1,600
Of course, this is the most basic formula for calculating interest. While it gives you a good baseline for understanding interest charges, it’s (unfortunately) not how some lenders choose to apply financing charges.
If you’re trying to determine just how much you’ll pay over the years on debt such as your student loans or even your credit card balance, you’ll need to learn a few more things.
Other Ways To Calculate Interest
While the concept of simple interest is foundational for understanding other types of interest, it doesn’t tell the whole story. That’s especially true when you start talking about the oft-used – but much more complicated – compound interest method.
Compounding is great when you’re on the receiving end, and it plays a significant role in things like investment portfolios. When you’re on the paying end, however, compounding can really hurt your pocket.
Most often, compound interest is used to calculate the finance charges on revolving credit card balances. Each day, your credit card company will take your balance, calculate interest, and add that additional interest charge to the principal balance owed. The next day, they’ll repeat the process … except that tomorrow, they’ll actually be charging you interest on the new principal balance, which includes that added interest from today.
Each day, you’re paying interest on your original purchases as well as interest on the interest from days past. It’s easy to see how credit card debt can quickly become so overwhelming, isn’t it?
To calculate compound interest, you’ll first need to know how often interest is compounded: daily, weekly, monthly, or annually. Then, you’ll need to know the rate at which the interest is applied.
If you know an account’s APR, you can figure out the compounding rate from that by simply dividing: a 6.00% APR that’s compounded once a month means a monthly compounding rate of 0.5% (0.06/12). If that same lender compounded once a day instead, the daily compounding rate would be 0.016% (0.06/365).
Summary: Start Simple To Learn About Interest
Understanding the concept of simple interest is imperative if you want to stay on top of your finances. Knowing how your debt, and your savings, will grow over time – and how much you’ll either pay or earn in interest – can guide many of your financial decisions.
While simple interest is a pretty easy formula to grasp, using a calculator on your phone or online can speed up the process. And if you’re curious about calculating compound interest, you can check out our comprehensive guide here.
Have any questions or just want to understand your next loan a bit better? Contact us to speak with a loan expert today.