Simple interest is the cost of using or borrowing money without compound interest or interest on interest. It's relatively easy to calculate since you only need to base it on the principal amount of money borrowed and time period.
Simple interest works in your favor when you're a borrower because it keeps the overall amount that you pay lower than it would be with compound interest. However, it can work against you when you're an investor because you'll want your returns to compound as much as possible to get the most from your investment.
To understand how it works, it helps to look at some real-life situations in which simple interest is used.
Car loans are amortized monthly, which means that a portion of the loan goes to pay the outstanding loan balance every month, and the remainder goes toward the interest payment. As the outstanding loan balance diminishes every month, the interest payable reduces, which means a greater part of the monthly payment goes toward the principal repayment.
For example, assume you have a car loan of $20,000 with simple interest at 4%. The loan is repayable over a five-year period in equal installments. Your payment would work out to be $368.33 per month over 60 months. In the first month, the interest payable on the full $20,000 loan amount is $66.67 ([20,000 x .04] / 12), which means that principal repayment is $301.66 (368.33 – 66.67). At the end of the first month, the principal amount is $19,698.34, on which interest payable is $65.66. The principal repayment in the second month is $302.67, and so on. By the end of the 60th month, the loan amount outstanding will be zero.
Other Consumer Loans
Department stores often offer major appliances on a simple-interest basis for periods of up to one year. So if you buy a refrigerator for $2,000 and pay simple interest at an annual rate of 8% in monthly installments, your monthly payment would be close to $174. This means that you would end up paying a total of $2,088, for total interest expense of $88. This is substantially less than the $160 you would have paid in interest expense if you had carried the $2,000 loan for the full year, instead of repaying a portion of it every month.
Certificates of Deposit
A certificate of deposit (CD) is a type of bank investment that pays out a specific amount of money on a set date. You can't withdraw money from a CD until that set date comes.
If you invest $100,000 in a one-year CD that pays interest at 2% per annum, you would earn $2,000 in interest income (100,000 x 0.02 x 1) after a year. If the CD pays the same annual interest rate but is only for a six-month period, you would earn $1,000 in interest income after six months (100,000 x 0.02 x .5).
Discounts on Early Payments
In the business world, suppliers often offer a discount to encourage early payment of their invoices. For example, a $50,000 invoice may offer a 0.5% discount for payment within a month. This works out to $250 for early payment, or an annualized rate of 6%, which is quite an attractive deal for the payer.