Simple Interest: Definition, How It Works And How To Calculate It
Simple interest is a fixed charge based on loan principal, and it’s typically assigned as a percentage. It’s a way of calculating how much you owe a lender for borrowing money. That cost of debt is called interest, and it can be determined via simple or compound interest formulas.
Mortgage lenders charge simple interest mortgage rates to borrowers to cover their expenses for paperwork, loan underwriting and other services. This interest is included in your monthly mortgage payments and is part of your expenses as a homeowner.
It’s important to understand what simple interest is and how it’s calculated so you can get a more accurate estimate of your monthly mortgage payments before you submit an offer on a house.
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How Do You Calculate Simple Interest?
Simple interest is based on your mortgage principal, or the total amount of money borrowed, and can be calculated with this formula:
Simple interest = principal x interest rate x number of years
So, if you borrow $100,000 with a 15-year term and 3% interest rate, your calculation would look like this:
$45,000 = 100,000 x 0.03 x 15
This shows that you’ll pay $45,000 in interest while repaying this loan. Next, you can add the interest total with your principal to determine the total amount you’ll pay the lender, which comes to $145,000.
In real estate, simple interest isn’t quite so simple. Your interest costs will be bundled with additional lender fees as an annual percentage rate (APR). This includes administration costs, origination fees and more. Calculating the APR costs you’ll owe each month with your mortgage payment requires a different formula:
APR = (((fees + interest) / principal / number of days in a loan term) x 365) x 100
Luckily, you don’t have to do this math yourself. Your lender is required to show you your loan’s APR, including all fees, scheduled payments and the total cost of your loan.
How Does Simple Interest Work In Real Estate?
Simple interest works the same in real estate as it does for other loan types. Your monthly payment will first cover your APR, which includes simple interest charges, and the remainder of your payment will contribute to paying off your principal balance.
While most mortgages don’t use compound interest (which charges interest on accumulated interest, as well as your principal), simple interest does take into account how your principal changes with payments.
Over time, you’ll generate less interest each month as your principal balance reduces. As APR charges decrease, more of your payments will go toward the loan balance, continuing to reduce your total interest charges.
Using our previous example, let’s say you’ve paid $33,333 of your $100,000 loan over the last few years. Your balance is theoretically down to $66,667 and it’s time to calculate your 12-month APR.
If you pay 3% in interest, your first interest payment was $3,000 and this was divided and added to your mortgage payments for 12 months. With your current balance, your next interest payment will only charge $2,000, because the principal your interest is based on is lower.
What Types Of Loans Use Simple Interest?
Simple interest is used for most common consumer debts, including auto loans, credit cards, student loans and mortgages. However, some lenders do apply compound or precomputed interest to debt, so it’s important to compare lenders and ask about simple loan options.
Typically, compound interest is utilized in investments, where you’re generating a return based on the amount you’ve invested. This includes 401(k)s, money market accounts, high-yield savings accounts and more.
How Can You Reduce Your Mortgage Interest Costs?
Buyers have two major decisions when borrowing money that can affect interest costs:
- Fixed vs. adjustable rates
- 15- vs. 30-year loan terms
Fixed-rate mortgages mean you’ll pay the same percentage of your principal in interest every month throughout your loan repayment. So if you signed for the loan at 3% interest, you’ll still pay 3% interest in 30 years.
Adjustable-rate mortgages (ARMs) provide an initial low interest rate for a set period of time after you borrow. This means you’re paying less interest when your balance is at its highest. However, after those first few years, your interest rate will fluctuate every 6 months or annually based on the market rates. This can increase your initial interest rate by as much as 5%, so ARMs are best for people with higher incomes and those planning to move within a few years.
Buyers can also choose between a 15- and 30-year loan term, which is the amount of time you’ll pay monthly mortgage payments. Of course, buyers are welcome to increase their monthly payments to repay the balance ahead of their set loan term, but this may trigger prepayment fees from your lender.
When you decide between a 15- and 30-year mortgage, the APR costs and impact to your principal balance are factored accordingly, so you’ll pay off the entirety of your loan, fees and interest charges by the end of the term.
Shorter loan terms mean fewer interest payments, so you can save more money in the long run. However, longer borrowing terms reduce your monthly payment, which is more affordable for many homeowners.
Your lender can provide the total expected cost between the two loan terms so you can make the decision that best fits your finances.
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Simple Interest Vs. Compound Interest
Simple interest is calculated based on the amount of money you borrow. The calculation may compound based on how your balance changes over time, but it doesn’t consider accrued interest.
Compound interest is a more complicated calculation because the formula does include how interest accrues annually, quarterly or semi-annually. So the amount of interest you owe will vary based on the principal and compounded interest.
Typically, compound interest loans or investments means the borrower will pay a larger sum by the end of the borrowing period. This is because the balance the interest is being charged on is decreasing at a slower rate than simple interest, which is calculated based on the principal as it decreases with payments over time.
How Do You Find the Principal Amount in Simple Interest?
Your principal amount is the original sum you borrowed, which will be available on your mortgage documents. You can also subtract your down payment amount from your home’s sale price to determine how much you borrowed to purchase your home.
- Principal = home sale price - down payment
Otherwise, you can adjust the simple interest formula to determine the principal amount if you know your interest rate, number of payments and interest paid. When you divide (interest rate x number of payments) from each side, you isolate the principal variable to create this formula:
- Principal = (simple interest) / (interest rate x time)
What Is the Formula for Compound Interest?
Compound interest is a little trickier to calculate, but you can use this formula to determine how much interest you’ll pay over the course of your loan:
- A = P (1 = (r / n )(n x t)
- A = interest paid
- P = initial principal
- r = interest rate
- n = number of times interest is applied per period
- t = number of periods
Is Simple Interest Good or Bad?
Simple interest isn’t good or bad, but whether it’s preferred over compound interest depends on if it’s applied to debt or investments.
Simple interest costs less than compound interest, so if you’re taking out a $350,000 loan for your dream home, simple interest is better for your budget.
However, if you’re calculating interest returns for your 401(k), compound interest will yield larger growth so you make more money off your investment.
Is Annual Percentage Rate Good or Bad?
Again, APRs aren’t good or bad. They’re just another way of packaging your interest rate to include additional lender fees, closing costs or other charges related to borrowing money.
APR is based on simple interest. There’s also annual percentage yield (APY), which is based on compound interest as well as the additional costs of borrowing money. Either can be applied to your mortgage, though APR is the more affordable option.
The Bottom Line
Interest rates have a significant effect on how much you’re actually paying for your home. Simple interest is typically a percentage of your loan’s principal, which will reduce over time as you pay more of your principal.
In the long run, simple interest costs less than compound interest payments, which account for accrued interest in addition to the principal balance.
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