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Simple interest is a quick method of calculating the interest charged on a loan. Simple interest is determined by multiplying the interest rate by the principal by the number of periods.Â

Where:Â
P is the loan amount
I is the interest rateÂ
N is the duration of the loan, using number of periods

For example, if Mr. Farmer borrows \$100,000 for one yearâ€”at a simple interest rate of 5%â€”he will pay 100,000 x 5% x 1, or \$5000, to borrow the money for one year.

Loans usually charge fees. Simple interest does not include these fees, so it will often not reflect the total cost of a loan. Simple interest also does not include the compounding effects of interest charged over time.

For example, Mr. Farmer may get a second loan bid from another bank for 5.15%. However, this loan may have much lower fees than the loan at 5%.

After accounting for fees, Mr. Farmer may find that it is cheaper to borrow money at 5.15% with low fees, than at 5% with high fees. This shows that simple interest by itself is not always the best way to compare loans.

To get a more accurate estimate of the true cost of a loan, people often look at the Annual Percentage Rate, or APR, which takes into account the effects of fees and compounding. Thus, it better reflects the true cost of a loan than the simple interest rate does.

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