Simple Interest
Definition
Simple interest is interest calculated only on the original principal amount of a loan or deposit. It does not compound — interest is not charged on previously accrued interest — which typically makes it less expensive for borrowers than compound interest.
How simple interest works
- Interest is expressed as a percentage rate and charged on the principal.
- The principal stays the same for the purpose of interest calculation (unless you make payments that reduce principal).
- Payments first go toward accrued interest; any remainder reduces principal.
- Because interest does not compound, total interest grows linearly with time.
Formula
Simple interest:
Simple Interest = P × r × n
where:
P = principal
r = annual interest rate (decimal)
* n = term in years
Total amount owed or accrued:
A = P × (1 + r × n)
Examples
- Student loan (simple interest)
- Principal: $18,000
- Rate: 6% (0.06)
- Term: 3 years
- Interest = $18,000 × 0.06 × 3 = $3,240
-
Total repaid = $18,000 + $3,240 = $21,240
-
Auto loan (simple interest)
-
Principal: $10,000
- Rate: 5% (0.05)
- Term: 5 years
- Interest = $10,000 × 0.05 × 5 = $2,500
-
Total repaid = $12,500
-
Comparable compound example (for contrast)
-
Same $10,000, 5% annual compounding, 5 years:
- Interest = $10,000 × (1 + 0.05)^5 − $10,000 ≈ $2,762.82
- Total repaid ≈ $12,762.82
Daily simple interest vs. standard simple interest
- Standard simple interest is calculated by period (usually annually) and applied per the formula above.
- Daily simple interest accrues each day on the outstanding principal; payments reduce the balance on the day they are received, which affects subsequent daily accruals. It’s more sensitive to the timing of payments.
Which loans use simple interest?
Common uses:
Auto loans
Many personal and some student loans
Some mortgages (many mortgages follow an amortization schedule that effectively uses simple-interest calculations per period)
Most coupon-paying bonds
Products that typically use compound interest:
Savings accounts and other deposit accounts (with frequent compounding)
Credit cards and many revolving lines of credit
Advantages and downsides
Advantages:
Predictable and easy to calculate.
Generally cheaper for borrowers than comparable compound-rate loans.
* Extra principal payments immediately reduce future interest costs.
Downsides:
Doesn’t benefit investors the way compounding does (no interest-on-interest).
Some loans called “simple” can still feel complex due to payment schedules, fees, or daily interest accrual.
How to lower total interest costs on a simple-interest loan
- Make extra principal payments when possible.
- Pay early in the billing cycle or as soon as funds are available (reduces daily accruals).
- Choose a shorter loan term or negotiate a lower rate.
- Use biweekly payment schedules to effectively make extra payments annually.
Simple vs. compound interest — key difference
- Simple interest is charged only on the original principal.
- Compound interest is charged on principal plus any interest that has been added (interest on interest). Over time, compound interest grows faster and will always yield a larger amount after the first compounding period.
Key takeaways
- Simple interest = P × r × n; it does not compound.
- It is commonly used for short- to medium-term loans and benefits borrowers by keeping total interest lower than comparable compound-interest loans.
- Making extra or earlier payments reduces total interest owed on simple-interest loans.