- Simple interest is a straightforward method of calculating interest on a loan. A borrower takes out a loan for an amount of money. That amount is called the principal. When he pays it back, he repays the principal amount as well as a certain amount of interest. Simple interest is calculated by multiplying the principal by the interest rate and multipying that by the time period of the loan. For example, if someone borrows $1,000 for 5 years at 10 percent interest, the amount of simple interest would be $1,000 times 10 percent times five, or $500.
- Simple interest is relatively easy to calculate. The formula for simple interest is straightforward and easy to understand, and it can be calculated manually by anyone with basic math skills or by using a calculator. It is often used to determine the interest charge on money loaned for a short period of time because of its simplicity.
- In Biblical times it was forbidden to charge interest on a personal loan by the Law of Moses. Over time, the charging of interest became an accepted practice because of the "time value" of money. When someone loans money, he can't use or invest that amount. Interest compensates him for the loss. Simple interest gives him a return on the principal in a way that can be easily calculated.
- Compound interest is another way to calculate the interest to be paid on a loan. Unlike simple interest, it adds the amount of compounded interest to the principal. Compound interest is used more frequently than simple interest in commercial loans and financial transactions.
- If you are lending or borrowing money, clarify up front whether simple interest or compound interest will be used to calculate the payback amount. If it's a personal loan, particularly if it's only for a short term, your calculations will be much simpler if you use simple interest. Both parties need to agree on the type of interest being used and the calculation of the total payback amount and payment schedule.
