Simple Interest: Meaning, Formula, and How to Calculate?

“As the saying goes, a little learning is a dangerous thing!” Little knowledge can be more harmful to you than it can be good. When it comes to investing as a beginner, we might learn about complex and technical terms but not about the basics. Therefore, it is always good to understand the basics before jumping into the more complex ones.

There are some fundamental concepts that everyone should know about, and one of them is simple interest. Whether you are a beginner in investing or a seasoned investor, it is important to grasp the basics of simple interest that can help you make informed decisions about investments.

What is simple interest?

Well, as the name says, simple interest is simple! It is an interest charge levied upon the amount the lender is giving to borrowers for a given time. It is a simple method to calculate the interest charge on a loan or principal amount.

Suppose,

You lend your best friend Ravi 50,000 INR and decide to charge a simple interest rate of 5% per year. At the end of one year, Ravi owes you 50,000 INR plus 2,500 INR as an interest charge. If Ravi takes  2 years. to pay you back, he owes you 50,000 INR plus 5,000 INR in total interest.

(i.e., 2,500 INR per year + 50,000, which equals to 55,000)

The formula for calculating simple interest is:

• Simple Interest = (Principal × Rate × Time)/100
• Where the principal amount is the initial amount.
• The rate is the interest rate you are charged.
• Time is the number of years you have given the principal amount.

Understanding the meaning of simple interest.

As we know now, simple interest is calculated by multiplying the principal amount by the interest rate and the period of the loan.

Think about renting your parking space to a person with a monthly rental agreement. You have made a deal with a certain amount of cash in hand and will receive 1,000 INR every month for a fixed period. The cash in your hand is the principal amount, and the monthly rental fee is the interest rate.

Voilà, you are getting paid; the person is getting the space! Both win!

Interest is what the borrower is paying for borrowing money from the lender. There is no need to calculate compound interest with simple interest. Compound interest is calculated based on the initial amount and the accumulated interest over time. So, simple interest is different from compound interest as it charges based on the principal amount 

Application of simple interest

Short-term personal loans and Simple Interest Automobile loans

Simple interest is used in some automobile loans or short-term loans for personal use. Personal loans are loans used for personal expenses that you can use for any purpose—covering medical expenses, buying electronics, furniture, etc.

Savings Accounts and Bonds

Bonds typically use simple interest, where the interest is paid out periodically based on a fixed coupon rate. Savings accounts often use compound interest, where interest is earned on both the principal and accumulated interest. Bonds generally offer easy, steady, and predictable returns.

Mortgages

Most mortgages use a complex method to calculate interest; yet, some short-term loans may offer more interest instead. For example, in the United States, mortgages follow amortization schedules. In accounting, an amortization schedule is a technique to gradually lower the value of a loan or intangible asset over time. In short-term mortgages, simple interest options if available, can help you navigate stressful financial situations.

For Example. Imagine buying a home while you have yet to sell your old one.It can be in a scary and uncertain situation! Short-term mortgage loans are gradually paid off using simple interest, making it easier for you without worrying about compounding. 

What are the benefits of simple interest?

Imagine you are buying your favourite book from a nearby shop for a set fee per day. You are at ease knowing that you have a clear plan to repay that in a fixed, predictable amount over a fixed period. Simple interest is like that; it is clear, easy to understand, and predictable!

The interest rate does not compound.

No one likes to be burned out with task after task on a busy Monday morning; it is exhausting! Simple interest doesn’t compound like an unfinished office task. Unlike compound interest, simple interest does not get compounded over a certain amount. Makes it easier for borrowers.

Cost savings for borrowers

Borrowers can save extra cash more easily. Loan repayments are easy for them  as they incur an amount that has a fixed interest charge. Total interest rates are much lower than compound interest loans.

Easy to clear debts

Predictable amounts to be consistently paid are easy to clear and manageable. The principal amount also decreases over time with repayments, reducing the debt load.

Easy to calculate

Simple interests are easy to calculate and straightforward. They are simple to understand, and you can easily calculate what goes into your pocket and how much you still owe.

Key takeaway!

• Simple interests are beneficial for people who want easy management, prosperity, and financial planning for their goals. For various personal and business needs, there are ways to manage and help you pay off the burdens. 
• Yet, simple interest only accounts for the general idea of a loan. It might not help you with other hidden charges and costs attached to the loan, such as late penalty fees, administrative costs, etc.
• Lenders charge high interest rates on simple interest to mitigate risks involving borrowers with low credit scores and a lack of assets.
• Regrets about your fluctuating credit score; the interest rates will always be fixed throughout the time, not allowing you the chance to avail yourself of better plans.

So, summing up the pros and cons, simple interest can be a good choice for borrowers with a lower financial budget. However, it is wise to carefully reflect on your needs and see if there are simply interest options available before making a decision about committing to any major loans.

Please share your thoughts on this post by leaving a reply in the comments section. Also, check out our recent post on: “What Is A Bear Market?“

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Disclaimer – This article is for educational purposes only and by no means intends to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.