Often we come across the term ‘interest rate’ when we have to borrow funds or invest money somewhere. An interest rate is the cost of financing that we pay when we take money on a loan and we get it when we have lent money or made the investment.
There are two types of interest: simple interest and compound interest. In this blog post, we’ll be discussing simple interest and how it works.
What is Simple Interest?
To start, let’s define simple interest. Simple interest is a type of interest calculation where interest is only earned on the original principal amount.
This means that if you have $100 in a savings account with a simple interest rate of 5%, you will only earn $5 in interest for that year.
Now that we know what simple interest is, let’s take a look at how it’s calculated. The formula for calculating simple interest is:
Interest = Principal x Rate x Time
It’s important to note that with simple interest, the interest is not compounded. If you don’t add any money to your account, you will only earn interest on the original $100.
Now that you know how simple interest works, you may be wondering why anyone would choose this type of interest over compound interest. After all, compound interest allows you to earn interest on your interest, leading to much higher earnings over time.
Also Read: What is a mortgage calculator?
Real life examples where simple interest is used
Simple interest is applied in various real-world financial scenarios where interest is calculated solely on the initial principal amount without compounding. Below are several practical examples where simple interest is commonly used, presented in a clear and structured manner.
Short-Term Personal Loans
Many personal loans, especially those with short repayment periods (e.g., 1–3 years), use simple interest. These loans are often offered by banks, credit unions, or private lenders for purposes such as home improvements, medical expenses, or debt consolidation.
Car Loans
Some auto loans, particularly those from smaller lenders or for used vehicles, use simple interest. The interest is calculated on the original loan amount, and borrowers pay a fixed amount of interest over the loan term.
Payday Loans
Payday loans are short-term, high-interest loans typically due on the borrower’s next payday. These loans often use simple interest due to their brief duration (e.g., 2 weeks to 1 month).
Why Choose Simple Interest Over Compound Interest?
There are a few reasons why someone might choose simple interest over compound interest. First, simple interest is typically lower than compound interest. This means that you won’t have to pay as much in interest over time.
Second, simple interest is easier to calculate than compound interest. This can be helpful if you’re trying to budget or understand your interest payments.
Third, simple interest can be a good option if you’re planning on withdrawing your money before the end of the term. With compound interest, you would have to pay interest on the interest that has accumulated, which can be costly.
Lastly, simple interest can be a good choice if you’re not comfortable with the risk associated with compound interest. With compound interest, your interest payments can fluctuate based on the market, which can be unpredictable.
If you’re considering adding interest to your savings, be sure to research both simple and compound interest to see which option is best for you.
