What Is Simple Interest?: A Definition And How To Calculate It
When you sign your name on the dotted line to borrow money, you should have a clear understanding of your interest rate – or the percentage of your loan that the lender will charge in interest each month. But have you ever wondered how much you’ll actually pay in interest over the lifetime of your loan?
Calculating how much interest you’ll pay can be tricky, especially when you learn there are multiple types of formulas, but simple interest is – as the name implies – relatively simple to both understand and calculate.
What Is Simple Interest?
Simple interest is a straightforward calculation that measures the amount of total interest a borrower will pay on a sum of money over a specified period of time. It’s typically a fixed interest rate determined by the initial principal balance of the loan.
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. However, the actual calculations for each will differ slightly. In this article, we’ll focus on simple interest as it relates to real estate debt.
How Does Simple Interest Work For Loans In Real Estate?
Before we get into calculating simple interest in real estate, you’ll need to understand a few basic loan terms. When you borrow any amount of money – whether that’s in the form of a financed car, a mortgage or a personal loan – 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.
Interest is applied to the principal balance throughout the loan period, which is how long you have to repay the debt. Exactly how much interest you pay will depend on the interest rate, which determines how much the lender will charge you each year in exchange for letting you borrow money. Simple interest loans typically have a fixed interest rate for the life of the loan.
When a borrower makes a monthly payment on a simple interest loan, their payment first goes toward the monthly interest charge and the rest toward the principal balance.
What Are The Types Of Loans That Use Simple Interest?
While some types of debt, like credit cards, will have more complicated interest structures, many loans utilize simple interest. Types of simple interest loans include:
- Personal loans
- Auto loans
- Student loans
- Home loans
Simple Interest Vs. Compound Interest Vs. Annual Percentage Rate
Simple interest is just one of the types of interest you might encounter on a loan or investment.
While simple interest has a fixed interest rate based on the principal amount of the loan, compound interest accumulates overtime, applying interest to the total amount owed as it changes. So if the loan has unpaid interest from the previous month, that interest will carry over to the next month.
In essence, compound interest can be considered “interest on interest.” For loans, this means you’ll end up paying more – but investment accounts with compound interest can also mean bigger gains.
Another term that is often confused with simple interest is APR. But where simple interest only accounts for the interest itself, the annual percentage rate (APR) of a loan also accounts for any additional loan fees, representing the total cost of the debt you owe. Because of this distinction, APR is often higher than simple interest.
Why Simple Interest Is Important
So why does simple interest matter? Knowledge is power, so understanding your loan terms and interest rates is always important when you’re borrowing money.
But simple interest can be a particularly powerful tool for responsible borrowers who make an effort to pay their loan bills early or on time each month, as simple interest is usually calculated on a daily basis.
This means by paying your bill earlier, you can ensure more of your payment goes toward the principal balance of the loan rather than the interest charges, lowering your principal and allowing you to pay off the loan sooner.
How To Calculate Simple Interest
As we’ve discussed, the three main factors that impact simple interest are the principal balance of the loan, the loan term and the annual interest rate. Once you have these details, 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.
What Is The Formula For Simple Interest?
The formula for simple interest is as follows:
Simple Interest = (Principal Balance) x (Interest Rate) x (# of Pay Periods)
Here’s an example to break it down further. Let’s say you borrow $10,000 at a 4.0% simple interest rate 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 4-year life of that loan, however, you will pay $1,600.
$10,000 x 0.04 x 4 = $1,600
Adding your simple interest and your principal balance will tell you precisely how much you’ll pay over the lifetime of your loan. In this example, you’ll pay $11,600.
The Bottom Line
Understanding the concept of simple interest is imperative if you want to stay on top of your finances. Knowing how your debt and savings will grow over time – and how much you’ll pay or earn in interest – can help you make shrewd decisions to better your financial future.
Interested in other ways to save over the lifetime of your loan? Learn more about a fixed-rate mortgage!