## What Is Simple Interest?

Simple interest is a quick and easy 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.

### Key Takeaways

• Simple interest is calculated by multiplying the daily interest rate by the principal, by the number of days that elapse between payments.
• Simple interest benefits consumers who pay their loans on time or early each month.
• Auto loans and short-term personal loans are usually simple interest loans.
1:42

## Understanding 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.

To understand how simple interest works, consider 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, the finance company calculates your interest 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 20 days in April, dropping your interest payment to $41.09, a$20 savings.

### The Formula for Simple Interest Is

\begin{aligned} &\text{Simple Interest} = P \times I \times N\\ &\textbf{where:} \\ &P = \text{principle} \\ &I = \text{daily interest rate} \\ &N = \text{number of days between payments} \\ \end{aligned}

Generally, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent. For example, say a student obtains a simple-interest loan to pay one year of college tuition, which costs 18,000, and the annual interest rate on the loan is 6%. The student repays the loan over three years. The amount of simple interest paid is: \begin{aligned} &\3,240 = \18,000 \times 0.06 \times 3 \\ \end{aligned} and the total amount paid is: \begin{aligned} &\21,240 = \18,000 + \3,240 \\ \end{aligned} ## Who Benefits From a Simple Interest Loan? Because simple interest is often calculated on a daily basis, it mostly benefits consumers who pay their loans on time or early each month. Under the scenario above, if you sent a300 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.

### Which will pay out more over time, simple or compound interest?

Compound interest will always pay more after the first payment period. Suppose you borrow $10,000 at a 10% annual interest rate with the principal and interest due as a lump sum in three years. Using a simple interest calculation, 10% of the principal balance gets added to your repayment amount during each of the three years. That comes out to$1,000 per year, which totals $3,000 in interest over the life of the loan. At repayment, then, the amount due is$13,000. Now suppose you take out the same loan, with the same terms, but the interest is compounded annually. When the loan is due, instead of owing $13,000, you end up owing$13,310. While you may not consider \$310 a huge difference, this example is only a three-year loan; compound interest piles up and becomes oppressive with longer loan terms.

### What are some financial instruments that use simple interest?

Most coupon-paying bonds utilize simple interest. So do most personal loans, including student loans, auto loans, and home mortgages.

### What are some financial instruments that instead use compound interest?

Most bank deposit accounts, credit cards, and some lines of credit will tend to use compound interest.