How to Define Simple Interest

Understanding how to define simple interest is an important aspect in business and finance. Simple interest is used in a variety of settings, from bank loans to brokerage house decisions to personal loans. Knowing the difference between simple interest and compound interest, for instance, can help you when reading loan contracts--either as a borrower or as a lender, as in the case of a private loan arranged between friends or family members. Whether you're computing a small, personal loan or going for something larger, like an equipment loan or student loan, knowing these basic finance terms is important. Learn how simple interest works and gain a firmer understanding of the world of finance and business.

Things You'll Need

• Calculator

Instructions

1. Define the word "interest." Interest is a set percentage of an amount of dollars that is calculated and paid to a lender. For instance, one might borrow $1,000 from a bank and have to pay interest on it--a set percentage that is paid in addition to the original loan and kept by the lender as a charge for the privilege of borrowing the original money.

2. Define the work "principal." Principal is the original amount of the loan. In the example in Step 1, the principal was $1,000. This is the amount the borrower originally borrowed, before interest.

3. Multiply the principal by the interest rate and by the time. For instance, if you borrow $1,000 at 5% interest for 1 year, the equation would read: 1,000 * .05 * 1 = 50, or $50. The simple interest on a 1-year loan of $1,000 is $50, so at the end of a year you would owe $1,050 using simple interest.

4. Calculate simple interest for multiple years by multiplying the interest by the number of years. For example, if you borrow $1,000 at 5% simple interest for 5 years, then at the end of 5 years the interest is $50 * 5 = $250, so the total amount due is $1,250--your principal plus simple interest.

5. Divide the total--principal plus total simple interest--by the number of months in a loan to determine a payback rate. As in the example in Step 4, a 5 year, 5% simple interest loan on $1,000 equals $1,250. You would divide by 60 (months) to get a payback rate, per month, or $20.83 per month.

Tips & Warnings

• Before you sign a loan contract, read the fine print carefully. There is a huge difference between compound and simple interest.