Simple Interest

Simple interest summary:

• Simple interest is a method of calculating interest.

• Simple interest is easy to calculate.

• On debt, simple interest is less costly than compound interest.

Simple interest definition and meaning

Simple interest is a method of calculating interest on a loan or investment. It's based on three numbers: 

• The original principal amount

• The interest rate

• The amount of time  

Some certificates of deposit (CDs) provide an example of how simple interest works. That means interest is calculated only on the initial deposit and doesn't compound over time. 

For example, imagine you deposit $1,000 in a 3-year CD paying 4% annual simple interest. Each year, you'd earn $40 ($1,000 x 0.04 = $40). When the CD matures, you would get your initial deposit of $1,000 back, plus $120 in interest ($40/per year). 

Key concept: Simple interest is a way of calculating interest on some loans and investments. It's based on the amount of principal borrowed or the amount invested.

More about simple interest

Like most things in life, there are both pros and cons associated with simple interest. Much depends on whether you're the borrower, lender, or investor. 

Advantages

• Simple interest is easy to understand, making it simple (pun intended!) to figure out how much interest you'll pay.

• Paying off a portion of a loan early reduces the total interest paid. 

• Any extra payments provide proportional interest savings.

• Lower cost for long-term loans since interest isn't compounded.

• If you can make large periodic payments, simple interest maximizes your savings. 

Disadvantages

• Simple interest loans are the exception rather than the rule, and finding one may not be easy. 

• Some loans are marketed as "simple interest," but interest is calculated daily. That makes the simple interest less simple.  

• Missing a payment on a simple interest loan could increase the total interest charged on the loan. If a lender calculates interest daily, paying late could increase your interest charges even if you pay within a grace period and aren't subject to a late fee.

• Late payments mean missing an opportunity to pay down the loan principal, and interest will continue to accrue on the unpaid principal amount. 

For investors, is better. You could earn more with compound interest. Each time you earn interest, you earn it on the new, higher amount.  

Simple interest: a comprehensive breakdown

Here are some account types that may offer simple interest (check with the lender): 

• Personal loans

• Car loans

• Student loans

• Bonds and other fixed-income investments

Every time you make a financial decision, you have plenty to consider. Understanding how simple interest works lets you quickly determine if the deal you're about to enter is in your best interest.