Understanding Simple Interest
Simple interest is calculated only on the original principal amount, using the formula I = P × r × t (Interest = Principal × Rate × Time). It's straightforward and commonly used for short-term loans, some bonds, and basic savings calculations. Unlike compound interest, simple interest doesn't earn interest on accumulated interest.
Simple interest is easier to calculate and understand, making it useful for quick estimates and certain financial instruments. For example, if you lend $5,000 at 5% simple interest for 3 years, you'll earn $750 in interest ($5,000 × 0.05 × 3), regardless of when the interest is paid. This predictability makes simple interest transparent for borrowers and lenders.
However, simple interest is less advantageous for long-term savings compared to compound interest. Over time, the difference becomes dramatic. For investments and retirement savings, compound interest vastly outperforms simple interest. Simple interest is typically found in short-term instruments like Treasury bills, short-term CDs, and certain loan structures.
Quick Tips
- Always compare APR, not just interest rates
- Use the Rule of 72 to estimate doubling time
- Extra payments dramatically reduce total interest
Frequently Asked Questions
Short-term loans, car title loans, some bonds, and basic interest calculations. It's rare for long-term savings or investments, which typically use compound interest for better growth.
Simple interest calculates on principal only. Compound interest calculates on principal plus accumulated interest. Over time, compound interest grows exponentially while simple interest grows linearly.
Yes, when borrowing, simple interest results in lower total interest paid compared to compound interest. However, most loans use amortization which is different from both simple and compound interest.
Yes, just use the fraction of the year. For 6 months, use 0.5 years. For 90 days, use 90/365 or approximately 0.247 years. The formula adapts easily to any time period.
Almost never for regular savings accounts. Banks use compound interest (daily, monthly, or quarterly) to stay competitive. Simple interest is mainly for specific financial products like short-term notes.