The fee paid on a sum of money, whether borrowed, loaned, or invested, is referred to as interest. Simple interest is a sort of interest computation that does not take compounding into consideration.
Compounding is the practice of earning (or being charged) interest on a regular basis, adding that interest amount to the principal balance, and then earning even more interest the following period due to the increasing account balance.
Simple interest is a method of calculating interest that does not take into consideration numerous periods of interest payments or charges. In other words, the interest rate will only apply to the principal amount of the loan or investment; any interest accrued will not be included.
Simple Interest Formula
The following formula is used to compute simple interest on investments and loans:
Simple Interest = I = P x R x T
P stands for principle, R stands for interest rate, and T stands for time.
To compute the total gains due to simple interest, however, a separate formula must be used. It is used by most online calculators, to calculate the amount you would get at maturity.
A = P (1 + r x t)
A denotes the entire amount (principal + interest), P the principal amount, r the interest rate, and t is the time.
How Simple Interest Works
Understanding simple interest is one of the most essential principles in financial management. It requires some easy math, but if you prefer, calculators may handle the job for you. Understanding how interest works empower you to make smarter financial decisions that save you money.
For instance, suppose you invest $100 (the principle) at a 3% annual rate for one year. The basic interest computation is as follows:
After one year, $100 x.03 simple interest x 1 year = $3 simple interest earned
It is worth noting that the interest rate (3%) is shown as a decimal (.03). You will need to convert percentages to decimals in order to perform your own computations. For example, to convert 3% to a decimal, divide 3% by 100, obtain .03.
If you wish to compute simple interest over more than one year, multiply the principal from the first year by the interest rate and the total number of years.
$100 x .03 interest rate x 3 years = $9 simple interest for three years.
Simple Interest Example
Sara receives a new personal loan for a short period of time. The loan is for $20,000 with a 3% interest rate for five years, thus she will owe $3,000 during the duration of the loan:
I = P x R x T
I = $20,000 x.03 x 5.
I = $3000
Each month, $50 of her payment goes toward loan interest.
Is Simple Interest Good or Bad
Borrowers who make timely payments benefit greatly from simple interest. Late payments are inconvenient because more money is diverted toward interest and less toward principal. Simple interest is most commonly used for short-term loans, such as personal loans.
Simple Interest Vs Compound Interest
The manner in which interest accumulates distinguishes simple interest from compound interest. Simple interest is solely calculated on the principal balance, whereas compound interest is calculated on both the principal balance and the accumulated interest.
When you borrow money, simple interest works to your advantage, but compound interest works better for you as an investor. Simple interest is preferable as a borrower since you are not paying interest on interest. Debt repayment is simpler with simple interest. Compound interest can help you accumulate wealth over time since your earnings earn money as well.
Simple interest is the most fundamental method for calculating the amount you will earn or pay for an investment or loan. Simple interest is calculated by multiplying the principal amount by the interest rate percentage and the time being measured.
While simple interest is a useful tool for establishing approximate predictions, it is typically considerably more accurate to consider an interest calculation that takes compounding into account.
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