Next video:
Loading the player...

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. 

Simple Interest

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

For example, if Mr. Farmer borrows $100,000 for one year—at a simple interest rate of 5%—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.

Related Articles
  1. Investing

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
  2. Investing

    Explaining Interest

    Interest is the price charged to borrow money, and is typically expressed as a percentage of the principal, or the amount loaned.
  3. Personal Finance

    Lending From A Loan Officer's Perspective

    Learn how a loan officer thinks, so that you can get the best and safest loan.
  4. Personal Finance

    Home Improvement Loans: What Are Your Best Options?

    If you plan on taking out a home improvement loan, you should know what your options are and which ones might be best for your situation.
  5. Personal Finance

    How To Apply For a Personal Loan

    Learn about different avenues for applying for a personal loan, and learn valuable tips to help you get your personal loan application approved.
  6. Retirement

    Business Owners: A Guide To Qualified Retirement Plan Loans

    Thinking of adding a loan feature to your company's plan? Here's what you need to know.
  7. Investing

    Learn Simple and Compound Interest

    Interest is defined as the cost of borrowing money, and depending on how it is calculated, it can be classified as simple interest or compound interest.
  8. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  9. Investing

    Understanding the Power of Compound Interest

    Understanding compound interest is important for both investing and borrowing money.
  10. Personal Finance

    8 Top Alternatives to Car Title Loans

    Before you sign up for a car title loan, investigate these 8 alternate strategies.
Hot Definitions
  1. Asset Allocation

    An investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's ...
  2. IRR Rule

    A measure for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of ...
  3. Short Covering

    Short covering is buying back borrowed securities in order to close an open short position.
  4. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  5. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  6. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
Trading Center