What is simple interest and how is it calculated?
- How to calculate simple interest
- How to calculate interest rate
Simple interest is a method of calculating the interest charged on a loan or earned from an investment based on the original principal amount. Interest is represented as a percentage. The reason it is “simple” is because it is based only on the original amount. That means that future interest calculations won’t include the interest that is added to the amount.
Here’s a quick example: If you loan someone $100 with the agreement that they will pay you 10% interest. They will pay you $110 back. $100 times 10% (or 0.1) is $10. They will repay the $100 in principal and $10 in interest.
In the United States, interest is almost always represented in annual terms. That’s why you will see the term “Annual Percentage Rate” and “Annual Percentage Yield.” That is the amount of interest as represented over 365 days. The APR is what you will pay when borrowing money and the APY is what you earn from investments.
If you are borrowing money, it is important to recognize that the interest rate is calculated at the daily level. So, let’s say that you borrow $1000 at a 24% interest rate. Remember that 24% is an annual number, so if you want to know what you will be charged in the first month, you divide 24% by 12 months. So, your monthly interest rate is 2%. You multiply your borrowed amount ($1000) by the monthly interest rate (2%) to see that you owe $20 in interest after one month.
Remember that this is simple interest. So, at the end of your second month, you will still be charged based on $1000. You don’t include the $20 of interest from last month.
In our example, let’s say you make a payment at the end of the first month of $520. Twenty of that is the interest you owe. The other $500 goes to pay off the principal. Now, let’s calculate the amount of interest you accrue in the second month. Your monthly interest rate is still 2%, but now you multiply that against your current balance, $500. The new interest is $10. At the end of the second month, you pay $510. $10 for interest and the rest goes to pay off the remaining principal.
For the two month loan, you paid a total of $30 in interest on borrowing the $1000. That’s only 3% of the total, but the APR is still 24%. The simple interest was charged as you go on the principal that you still owed.
So, that’s the simple explanation on simple interest. If you found this information helpful, please consider liking this video and subscribing to our channel. Thanks for watching.
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