What is simple interest? And how is it different from compound interest?

What is simple interest? And how is it different from compound interest?

Americans owe trillions of dollars in loans: car loans, bill-paying loans, student loans, emergency loans. Loans on loans.

But many don’t understand how interest is charged on loans – and how that can make them very expensive. Calculating interest can be a bit complicated, in the case of compound interest. Or it can be quite simple, if you pay what is called simple interest.

Here’s how simple interest works when you pay off a loan.

How Simple Interest Works

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Simple interest is generally used when calculating interest on a loan.

Loans are not free.

As a borrower from a financial institution, you are not only required to repay the full amount borrowed, but mainbut pay the cost of borrowing, interest. Think of interest as a fee the bank charges for lending you money.

Conversely, when you earn interest in a high-yield savings account, the bank pays you a fee to use your money to lend to people.

Simple interest is calculated only on the initial amount borrowed or deposited. This contrasts with compound interest, which is earned equally on principal and interest – piling interest on top of interest.

Calculation of simple interest

Happy couple with a car salesman, buying a new car with their loan.

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With simple interest, the interest you pay or receive each year is the interest rate – which is annual – multiplied by the principal.

To calculate simple interest, take the interest rate – which is annual – and multiply it by the principal. Then multiply again by the number of years.

It’s that simple.

Here is an example of how simple interest works:

Tom needs a new car and needs an unsecured loan to cover the cost, which is $10,000.

His credit score is fine, so the bank gives him a loan of $10,000, to be repaid over the term of the loan: two years. He gets an interest rate of 8%.

Tom’s interest for one year would be $800: his principal ($10,000) multiplied by the interest rate (8% or 0.08). His total interest is $1,600: $800 multiplied by two (the number of years). He will therefore have to repay a total of $11,600.

See for yourself how simple interest works. Use an auto loan calculator that factors in simple interest and a number of other factors.

Where do you pay simple interest?

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Mortgages are simple interest loans. The size of the main just makes it look like it’s getting worse.

Simple interest generally applies to auto loans, student loans, and even mortgages.

You may also see simple interest on consumer loans. Some department stores allow you to finance appliances with simple interest for periods of 12 to 24 months.

For example, you could buy a vacuum cleaner for $300 in monthly installments at 8% interest. In the end, you will pay a total of $324, in monthly installments of $27.

Simple interest on loans can be better for your finances than more expensive compound interest, which is charged on credit cards. Simple interest makes debt more manageable.

This is why consumers are often recommended to take out personal loans to pay off credit card debt.

Where else does simple interest appear?

Smiling multiracial couple clients shaking hands with financial advisor

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Certificates of deposit come in a multitude of terms. Meet with a financial advisor to review the different options.

Simple interest is also often associated with certain investment vehicles. Some certificates of deposit use simple interest for their returns.

Take a $100,000 investment in a one-year CD at 3% APY. After one year, the income amounts to $3,000 in interest income.

With a six-month CD, the gain would be $1,500, due to the shorter time frame.

Now that you’re armed with a better understanding of simple interest, you should feel more comfortable discussing loans with your bank.

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