Definition Formula
The following examples are word problems where the simple interest is known, but it is necessary to calculate the rate of interest, principal amount, period, or total amount. We use the formulas below to calculate the amount of money paid back at the end of the given time. The following formulas are also used when the missing values are the principal amount, rate of interest, or time. Mohit pays Rs 9000 as an amount on the sum of Rs 7000 that he had borrowed for 2 years. Namita borrowed Rs 50,000 for 3 years at the rate of 3.5% per annum. Get instant access to video lessons taught by experienced investment bankers.
Both methods use the same formula to calculate simple interest. Lowering the interest rate, shortening the loan term, or prepaying principal also has a compounding effect. When calculating simple interest, the rate of interest must be converted to decimal, and if the time spans over months, it must be converted to years. After two years, a woman with \$50000 in a bank received \$5000 in interest on her investment. Find the interest rate that was paid on the money that was deposited. If you have a savings account, the interest will increase your balance based upon the interest ratepaid by the bank.
Simple Interest Formula
Let us see some simple interest examples using the simple interest formula in maths. Since interest is a function of the outstanding principal as of raleigh bookkeeping the corresponding date, the gradual increase in the principal causes the interest payments to rise in tandem. In short, simple interest neglects the effects of compounding, which can be best described as “interest on interest”. Simple Interest refers to a interest rate pricing structure in which the amount of interest owed is based only on the original principal value. You wouldn’t get your $4,166 every month, but you’d have 131 times more in the bank after 100 years. Simple interest can be used both when you borrow or lend money.
The real-life examples of simple interest loans
Simple interest is a type of interest that is calculated only on the initial amount borrowed/invested, without considering any interest charged/earned in previous periods. It is a fixed percentage of the principal amount that is charged or earned over a specific period of time. In this lesson, you will be introduced to the concept of borrowing money and the simple interest that is derived from borrowing. You will also be introduced to terms such as principal, amount, rate of interest, and time period. Through these terms, you can calculate simple interest using the simple interest formula. There is another type of interest called compound interest.
- To calculate simple interest monthly, we have to divide the yearly interest calculated by 12.
- In finance, interest rate is defined as the amount that is charged by a lender to a borrower for the use of assets.
- Simple interest is used in cases where the amount that is to be returned requires a short period of time.
- For example, when you borrow funds with a credit card, you might estimate how much interest you pay using simple interest.
- After that, you return the money whenever you get the next month’s pocket money from your parents.
- It involves some simple math, but calculators can do the work for you if you prefer.
Suppose you borrow $10,000 at a 10% annual interest rate with the principal and interest due as a lump sum in three years. Using a simple interest calculation, 10% of the principal balance gets added to your repayment amount during each of the three years. That comes out to $1,000 per year, which totals $3,000 in interest over the life of the loan. On the other hand, calculations become easy when banks apply simple interest methods. Simple interest is much more useful when a customer wants a loan for a short period of time, for example, 1 month, 2 months, or 6 months.
Therefore, Martha made an initial deposit of \$5000, which paid her \$900 over three years at a simple rate of 6%. ( b ) Calculate the total amount that she must pay to the bank, including the principal and interest. Stephanie took out a loan from the bank for \$5200, and they charged her \$182 in simple interest over a year.
Simple interest can be advantageous for borrowers because of its relatively lower cost of money. However, bear in mind that, because of its simple calculation, it gives only a basic idea of cost that may not account for other charges/fees that a loan may include. Compound interest is often a factor in business transactions, investments, and financial products intended to extend for multiple periods or years. Typically, simple interest is used for loans of a single period or less than a year. If you don’t let the principal payments vary, as in an interest-only loan (zero principal payment), or by equalizing the principal payments, the loan interest itself doesn’t compound.
Step 2. Compound Interest Calculation Example
While you may not consider $310 a huge difference, this example is only a three-year loan; compound interest piles up and becomes oppressive with longer loan terms. As a reminder, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent. Let us now substitute the given into the formula to calculate the simple interest.
These costs will affect the total amount that you spend on the loan throughout the year, but they may not be included in the interest rate given to you by the lender. Now, we can also prepare a table for the above question adding the amount to be returned after the given time period. Another type of problem you might run into when working with simple interest is finding the total amount owed or the total value of an investment after a given amount of time.
In that case, it is called the annual percentage yield (APY) or the effective annual rate (EAR). It is a price that the borrower pays to the lender for using his money. The interest is customarily expressed as a percentage (%) of the original amount (principal amount, balance). For loans such as 30-year mortgages, for example, simple interest calculations aren’t an entirely accurate way to compute your costs since they don’t account for closing costs. Those costs are included in your APR, which is typically higher than your interest rate.
On the consumer side, borrowing money that charges simple interest capital expenditures and other cash needs for a business benefits you because it will cost you less than compound interest. Simple interest is a way of measuring interest that does not account for multiple periods of interest payments or charges. The interest rate will only apply to the principal amount of the loan or investment—accrued interest doesn’t affect it. Simple interest is a method of interest that always applies to the original principal amount, with the same rate of interest for every time cycle.
If you make partial payments to a simple interest loan, the payment will be applied to interest first, and any remainder will be used to reduce the principal. The compounding feel comes from varying principal payments—that is, the percentage of your mortgage payment that’s actually going towards the loan itself, not the interest. Simple interest usually applies to automobile loans or short-term personal loans.
( a ) Determine the principal amount you borrowed if the simple interest is \$1200. Now, plug the data into the formula to find the principal amount. ( a ) Determine the principal amount you borrowed if the simple interest is \$200.
Car loans or auto loans use simple interest to calculate the interest. The borrower agrees to pay the money back, plus a flat percentage of the amount borrowed. But in case the borrower fails to repay the amount on time, the company or the lender may start charging compound interest. This may seem high, but remember that in the context of a loan, interest is really just a fee for borrowing the money.
That means you’ll always pay less interest with a simple interest loan than a compound interest loan if the loan term is greater than one year. Therefore, the interest earned after holding the money for 2 years and 3 months is \$393.75. Let us now calculate the simple interest by substituting the known values into the formula.