What is Simple Interest?
Simple Interest is a quick and straightforward method of calculating the interest charge on a loan or the interest earned on an investment. Unlike compound interest, simple interest does not accumulate on top of previously earned interest—it is only ever calculated against the original principal amount.
The Mathematics
The universal formula for simple interest is:
I = P × R × T
- P (Principal): The starting amount of money.
- R (Rate): The annual interest rate (e.g., 5% becomes 0.05).
- T (Time): The time period, usually measured in years.
If you borrow $10,000 at a 5% simple interest rate for 3 years, you only pay 5% of $10,000 ($500) each year. Over three years, you'll pay exactly $1,500 total in interest.
Common Uses
Simple interest is commonly used for short-term personal loans, car loans, and some specialized Certificates of Deposit (CDs). However, most modern savings accounts, index funds, and credit cards utilize Compound Interest.