What is 'Simple Interest'
Simple interest is a quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the daily interest rate by the principal by the number of days that elapse between payments.
This type of interest usually applies to automobile loans or short-term loans, although some mortgages use this calculation method.
BREAKING DOWN 'Simple Interest'
When you make a payment on a simple interest loan, the payment first goes toward that month’s interest, and the remainder goes toward the principal. Each month’s interest is paid in full so it never accrues. In contrast, compound interest adds some of the monthly interest back onto the loan; in each succeeding month, you pay new interest on old interest.
Examples of Simple Interest
To understand how simple interest works, examine an automobile loan that has a $15,000 principal balance and an annual 5% simple interest rate. If your payment is due on May 1 and you pay it precisely on the due date, your interest is calculated on the 30 days in April. Your interest for 30 days is $61.64 under this scenario. However, if you make the payment on April 21, the finance company charges you interest for only for 20 days in April, dropping your interest payment to $41.09, a $20 savings.
Who Benefits From a Simple Interest Loan?
Because simple interest is calculated on a daily basis, it is mostly beneficial for consumers who pay their loans on time or early each month. Under the scenario above, if you sent a $300 payment on May 1, then $238.36 goes toward principal. If you sent the same payment on April 20, then $258.91 goes toward principal. If you can pay early every month, your principal balance shrinks faster, and you pay the loan off sooner than the original estimate.
Conversely, if you pay the loan late, more of your payment goes toward interest than if you pay on time. Using the same automobile loan example, if your payment is due on May 1 and you make it on May 16, you are charged for 45 days of interest at a cost of $92.46. This means only $207.54 of your $300 payment goes toward principal. If you consistently pay late over the life of a loan, your final payment will be larger than the original estimate because you did not pay down the principal at the expected rate.
What Types of Loans Use Simple Interest?
Simple interest usually applies to automobile loans or short-term personal loans. Most mortgages do not use simple interest, although some banks use this method for mortgages that have a bi-weekly payment plan. Bi-weekly plans help consumers pay off their mortgages early because the borrowers make two extra payments a year and more frequent payments result in interest savings.