What is the definition and meaning of simple interest?
Interest is one of the most important terms in business, and it is critical to understand how interest works to get a hold of your personal finances.
Having an accurate knowledge of interest will greatly improve your financial acumen, and be critical in understanding more complex financial terms.
This article looks at the easiest method of calculating interest, which is simple interest.
Understanding the Concept of Interest
In a simple interest loan, the payment you make on the loan goes towards the interest initially, with the rest of the payment going towards the principal.
Because of paying interest first, it does not accumulate value and you do not need to pay any additional interest.
On the other hand, compound interest adds interest back to the original loan value, therefore each month you are paying additional interest on the prior months interest which has been added back to the loan amount.
Simple Interest Definition
Simple interest is a quick and easy method of calculating the interest charge on a loan. It is calculated by multiplying the daily interest rate by the principal, by the number of days that elapse between payments.
Simple interest is the easiest method for computing the interest of a loan. It is an easier method than compound interest, and is also a better method for those who pay their loans on time and in full.
This interest calculation is based on the original amount of the loan, the interest rate you pay, and the number of periods you make payments over.
Because it is the simplest method for computing interest, there are often other methods such as compound interest which are used in place of the simple interest formula.
How to Calculate Simple Interest (Formula)
The formula for simple interest is easy, as the name implies.
The formula is A = P ( R * T ).
In this formula;
A = the amount of interest
P = the principal of the loan
R = is the interest rate
T = is the time of the loan.
Therefore to get simple interest, you multiply the principal amount by the rate times the time of the loan.
For example, the simple interest on a $1,000 loan with a 10% interest rate for 5 years would be $1,000 * ( 0.02 * 5 ) = $100.
So you are paying $100 of simple interest for the 5 years of the loan.
Also Read: Simple interest versus compound interest – the difference
What Types of Loans Use This?
There are different types of loans but a vast majority of loans use simple interest. Some of the most common types of simple interest loans are car loans and short term personal loans.
It is critical that simple interest is used instead of compound interest in order for you to minimize the total amount you pay on the loan.
Conversely, many mortgages use compound interest, leading to very high payments on your home.
Key Takeaways About Simple Interest
– Simple interest pays the full amount of interest for the month, so no interest is added back into the loan for the next month.
– Simple interest is the easiest method for computing interest, and is the best method for those who make full and on time payments on their loans
– The formula: A = P *( R * T ) – Auto and student loans commonly use simple interest.
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