What Is Simple Interest?
Simple interest is a type of interest which can be charged by lenders on loans or paid by banks on savings accounts. Unlike compound interest, simple interest is charged only on the principal and, as the name implies, its calculation is quite straightforward.
In this article, we will take a look at simple interest, demonstrate how to calculate it, analyse simple interest vs compound interest and much more.
Table of Contents
Key Insights:
- Simple interest is interest which is only calculated on the principal amount of a loan.
- It is calculated by multiplying the original loan amount by the interest rate and then by the term of the loan.
- For borrowers, simple interest can result in a lower cost of borrowing over time.
- For savers, simple interest will generate a lower return than compound interest.
What Is Simple Interest
Simple interest is a method of calculating interest whereby interest calculations are always applied to the original, or principal, amount. It does not include compounding interest.
When borrowers take out a loan which charges simple interest, the interest charged will be calculated using the original loan amount only. Similarly, savers who deposit money in savings accounts which pay simple interest will only ever earn interest on the amount they deposit.
We’ll look at both of these examples in more detail shortly. But, firstly, let’s look at how simple interest is calculated.
Calculation of Simple Interest
Calculating simple interest is an uncomplicated affair. It’s calculated by multiplying the principal sum by the interest rate and then by the term of the loan or saving period, as follows:
| Simple Interest = (Principal x Interest Rate) x Term |
How Simple Interest Works in Practice
Simple interest can be charged or paid on loans and savings accounts respectively. In the following sections, let’s take a look at how to calculate simple interest using an example of each.
Borrowing
Lenders offer simple interest on a variety of loans; this can include short-term loans and automobile financing.
When entering into a loan which charges simple interest, borrowers are charged interest based on the original loan amount.
Let’s say that a borrower takes out a loan for £10,000 which charges simple interest at an annual rate of 5% and has a term of four years.
Using the formula from the previous section, we can calculate how much interest our borrower has to pay over the term of the loan:
| (£10,000 x 0.05) x 4 = £2,000 |
The total amount of interest charged over the four years will be £2,000, meaning that the total repayment amount for the loan is £12,000.
Savings
The majority of savings accounts pay compound interest; however, you may find some which pay simple interest.
When savers save money in an account which pays simple interest, interest is only ever paid on the amount of money which they deposit. This is in contrast to accounts which pay compound interest, whereby interest is also paid on any interest which has accrued.
Let’s imagine that a saver deposits £7,500 in a savings account which pays simple interest at 3.5% per annum. The saver leaves the money in the bank for five years without making any withdrawals or adding any money.
In this case, the amount of interest earned by our saver would be calculated as follows:
| (£7,500 x 0.035) x 5 = £1,312.50 |
In this scenario, our saver has earned £1,312.50 worth of interest over the five-year period examined, taking the total balance of their savings account to £8,812.50.
Simple Interest and Compound Interest
When you borrow or save money, the interest which is charged or paid is either simple or compounded.
As already shown, simple interest is only calculated on the original amount. However, compound interest refers to scenarios where interest is charged or paid on both the principal and on the interest which accrues over a given period.
Compound interest is calculated thus:
| Compound Interest = Principal x (1 + Interest Rate)N – Principal |
- Where ‘N’ is the number of years interest is applied.
The effect of compound interest has different implications on borrowing and saving.
Borrowing
Generally speaking, when it comes to borrowing money, borrowers will pay less over time on loans which charge simple interest than on those which charge compound interest.
For example, let’s take another look at our previous example of borrowing, where our borrower entered into a loan for £10,000 which charged simple interest at a rate of 5% over a term of four years. Over the lifetime of the loan, the borrower paid £2,000.
Let’s imagine that the interest had instead been compounding over the same time period:
| £10,000 (1 + 0.05)5 - £10,000 = £2,762.82 |
With a loan charging compound interest, our borrower would have paid £762.82 more in interest
Savings
However, when it comes to saving, compound interest - which is offered by most saving accounts - is more advantageous for the saver.
For example, earlier, we looked at an example where a saver deposited £7,500 into a savings account paying simple interest of 3.5% per annum and left it there for five years. Over the five-year period, the total amount of interest earned was £1,312.50.
Let’s now imagine that the interest had, instead, been compounding annually. In this scenario the calculation would have been as follows:
| £7,500 x (1 + 0.035)5 - £7,500 = £1,407.65 |
With compounding interest, our saver would have earned £95.15 more interest over the same five-year period.
Conclusion
Simple interest refers to interest which is calculated only on the principal of a loan. It is calculated by finding the percentage of the original amount and multiplying it by the relevant time period.
This is in contrast to compound interest, where interest is charged periodically on both the principal and any interest which has already accrued.
For borrowers, simple interest may be preferable, as it generally results in lower interest payments over time. However, when it comes to saving money, an account which pays compound interest can allow savings to grow quicker over time than a similar account which pays simple interest.
Education from Admiral Markets
Want to learn more about finance and the financial markets? At Admiral Markets, we have a constantly growing collection of educational articles which cover a wide variety of topics. Click the banner below to browse our educational content:
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
