Simple Interest

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Simple Interest

Definition

Simple interest is interest calculated only on the original principal amount of a loan or deposit. It does not compound — interest is not charged on previously accrued interest — which typically makes it less expensive for borrowers than compound interest.

How simple interest works

  • Interest is expressed as a percentage rate and charged on the principal.
  • The principal stays the same for the purpose of interest calculation (unless you make payments that reduce principal).
  • Payments first go toward accrued interest; any remainder reduces principal.
  • Because interest does not compound, total interest grows linearly with time.

Formula

Simple interest:
Simple Interest = P × r × n
where:
* P = principal
* r = annual interest rate (decimal)
* n = term in years

Total amount owed or accrued:
A = P × (1 + r × n)

Examples

  1. Student loan (simple interest)
  2. Principal: $18,000
  3. Rate: 6% (0.06)
  4. Term: 3 years
  5. Interest = $18,000 × 0.06 × 3 = $3,240

  6. Total repaid = $18,000 + $3,240 = $21,240

  7. Auto loan (simple interest)

  8. Principal: $10,000
  9. Rate: 5% (0.05)
  10. Term: 5 years
  11. Interest = $10,000 × 0.05 × 5 = $2,500

  12. Total repaid = $12,500

  13. Comparable compound example (for contrast)

  14. Same $10,000, 5% annual compounding, 5 years:
  15. Interest = $10,000 × (1 + 0.05)^5 − $10,000 ≈ $2,762.82
  16. Total repaid ≈ $12,762.82

Daily simple interest vs. standard simple interest

  • Standard simple interest is calculated by period (usually annually) and applied per the formula above.
  • Daily simple interest accrues each day on the outstanding principal; payments reduce the balance on the day they are received, which affects subsequent daily accruals. It’s more sensitive to the timing of payments.

Which loans use simple interest?

Common uses:
* Auto loans
* Many personal and some student loans
* Some mortgages (many mortgages follow an amortization schedule that effectively uses simple-interest calculations per period)
* Most coupon-paying bonds

Products that typically use compound interest:
* Savings accounts and other deposit accounts (with frequent compounding)
* Credit cards and many revolving lines of credit

Advantages and downsides

Advantages:
* Predictable and easy to calculate.
* Generally cheaper for borrowers than comparable compound-rate loans.
* Extra principal payments immediately reduce future interest costs.

Downsides:
* Doesn’t benefit investors the way compounding does (no interest-on-interest).
* Some loans called “simple” can still feel complex due to payment schedules, fees, or daily interest accrual.

How to lower total interest costs on a simple-interest loan

  • Make extra principal payments when possible.
  • Pay early in the billing cycle or as soon as funds are available (reduces daily accruals).
  • Choose a shorter loan term or negotiate a lower rate.
  • Use biweekly payment schedules to effectively make extra payments annually.

Simple vs. compound interest — key difference

  • Simple interest is charged only on the original principal.
  • Compound interest is charged on principal plus any interest that has been added (interest on interest). Over time, compound interest grows faster and will always yield a larger amount after the first compounding period.

Key takeaways

  • Simple interest = P × r × n; it does not compound.
  • It is commonly used for short- to medium-term loans and benefits borrowers by keeping total interest lower than comparable compound-interest loans.
  • Making extra or earlier payments reduces total interest owed on simple-interest loans.