How Is Simple Interest Calculated?
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Introduction
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Interest is the amount paid on a loan over time; it is the cost of the loan. Interest is paid by a borrower, whether it is someone taking out a mortgage or a bank holding a Certificate of Deposit. As the name implies, simple interest is a bit easier to calculate than other forms of payment over time. "Simple" refers to the fact that interest is only paid on the original principal; in other words, it is not compounded.
Simple Calculations
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The formula for simple interest requires three key pieces of information. The first is the principal, the amount of money on which interest is being paid. The second is the interest rate, and the third is the term, or duration, of the interest-bearing relationship. Multiplying these three together yields the amount of interest paid. For example, $100 borrowed at 2 percent interest for 5 years would yield $10 in interest since 100 x .02 X 5 = 10. In this case the interest is relatively low because the term and the rate are small. A realistic mortgage might have a rate of 6 percent and a term of 30 years. On the same $100, this scenario would result in $180 of interest, more than the original principal amount. Thus, even simple interest can generate a significant level of return for a lender. Note that the interest rate is almost always given as an annual figure. If the term is less than a year, then a corresponding fraction of the rate must be used to calculate the simple interest. So, $100 lent at 6 percent annual interest for 6 months yields $3, or 100 x .06 X .5 since 6 months is half of a year. In some cases, simple interest is paid daily, which means the annual rate is divided by 365 to find the effective daily rate.
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Simple vs. Compound Interest
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In most real-world situations, such as a savings account or credit card debt, interest adds up far more quickly since the interest for each period is added to the principal for the next period. Interest paid to a savings account increases the balance and, if no funds are withdrawn, the higher balance will be used to calculate the next interest payment. Similarly, the credit card lender will add any unpaid charges and fees to the balance for the next billing cycle. Turning simple interest, such as that paid on a bond or a Certificate of Deposit, into compound interest by reinvesting all interest payments can significantly increase the overall yield for an investor.
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