Simple interest is a term used to describe loans and savings accounts that don’t charge or earn interest on existing interest. It is a common method of managing interest where interest is either paid or paid out as it is generated, rather than compounding.
Simple interest methods are often used for short-term loans such as personal loans and car loans, and unsecured loans are the most common type of simple interest loan.
What is Simple Interest?
Simple interest is an easy method of calculating the interest charges on a loan. Simply take the principal money, also known as the outstanding balance and multiply it by the daily interest rate, then by the payment frequency. This will then give you the interest charge per payment period.
Simple interest can be advantageous for borrowers as the total interest charged is lower when using the simple interest method, rather than compound interest. This is because interest is never charged on interest that has already been accrued, meaning you only pay interest on the principal amount.
The flipside to this is that simple interest leaves savers at a disadvantage compared with accounts that offer compound interest – the ability to earn interest on interest.
How does Simple Interest work?
A borrower has taken a personal loan with simple interest of £10,000 and 6% interest per year (charged daily), and monthly payments, the interest would work as follows:
The first step is to calculate the daily interest rate as follows – annual interest rate/365
For a 30-day month, on the above example, the months’ interest charge would be £49.32.
This is calculated by multiplying the daily interest rate by 30 (as there are 30 days in the month) and then multiplying this percentage by the principal amount.
Using another example with capitalised interest, for example, a student loan, we can see how simple interest adds to a loan.
The loan balance is £15,000 and the annual interest rate is 3%, which is not yet due and will be repaid at a later date.
Here we use the following calculation to work out how much the borrower will owe at the end of the year:
£15,000 x 0.03 = £450
What are the key facts about Simple (Regular) Interest?
The key facts and features of simple interest are the following:
- Loans with simple interest will have lower interest charges than ones with compound interest.
- Savings accounts that accrue simple interest will attract less interest than ones that accrue compound interest.
- Simple interest is calculated by multiplying the daily interest by the loan balance and then multiplying it by the number of days between payment periods.
- Simple interest does not compound, meaning you will never pay interest on existing interest charges.
What is the Formula of Simple Interest?
Simple interest can be calculated using the following formula:
SimpleInterest=P×r×n
where:
P=Principalamount
r=Annualinterestrate
n=Termofloan,inyears
While the simple interest definition and formula may be a lot to take in initially, we will explain everything further throughout the article.
What is a Simple Interest Loan?
A simple interest loan is a type of short-term loan that uses the simple interest method of charging interest on the principal balance. Common loan types that use simple interest are personal loans, car loans, unsecured loans and many types of mortgages.
How can I calculate simple interest?
The easiest way to calculate the amount of interest that you will pay on your loan is by using a simple interest calculator. This method allows you to quickly and accurately work out your likely costs. Alternatively, you can use the formula mentioned above, although this is more prone to mistakes.
Who benefits most from simple interest?
As simple interest results in borrowers paying less interest than would be the case on a compound interest loan, the borrower is the biggest beneficiary, with the lender receiving less interest. Of course, the amount of interest that you pay will still depend on your loan balance and your interest rate.
What types of loans use simple interest most commonly?
As mentioned earlier, there are certainloan typesthat commonly use simple interest. The main ones are the following:
- Personal loans
- Car loans
- Unsecured loans
- Mortgages
- Secured loans
- Credit cards
Of course, simple interest loans are popular with borrowers due to the potential interest savings on their loan balance.
What is the history of Simple Interest?
Simple interest dates back to 5000 BC, where interest was charged on seeds and animals sold, with it being justified by the fact that they can reproduce themselves, adding value in the process. As the use of interest grew, interest history then split in 2400 BC with the introduction of compound interest.
The Bank of England Base Rate became the predominant interest rate in the UK when it was invented in 1694 and was originally set at 6%. This dropped as low as 0.25% in 2018 after going as high as 17% in November 1979.
Why is simple interest known as simple?
Simple interest took its name from being the simplest form of calculating interest. By charging an agreed rate based on the loan balance, with no daily change needed as interest is capitalised, it is considered to be simple in financial terms.
Are Basic Interest and Simple Interest the same?
Yes, simple and basic interest are terms that can be used interchangeably, although ‘simple’ is the more commonly accepted term.
What are the other interest types?
The other types of interest that are commonly charged on loans are the following:
- Fixed rate interest – Fixed rate mortgages
- Variable rate interest – a variable rate can increase or decrease depending at the lender’s discretion and external economic factors. Variable rates tend to be closely aligned to the Bank of England Base Rate.
- Discounted rate interest – this type of interest is often charged on mortgages and is usually based on a lender’s standard variable rate. The lender then offers a discount on their variable rate, meaning lower interest charges for the borrower.
Simple and compound interest can be combined with the above interest types when taking out a loan or mortgage, meaning you could have a fixed-rate mortgage, with simple interest.
What is the difference between simple interest from compound interest?
Simple interest vs compound interest can be explained by expanding on how interest is charged. Simple interest is charged only against the loan balance, whereas compound interest is calculated against the loan balance plus any interest that has been charged, but not yet paid.
For a bridging loan at £100,000 with interest at 1% per month, the interest charged would work as follows:
Simple interest: £100,000×1%=£1,000 per month.
Compound interest: £100,000×1% =£1,000, meaning the new balance is £101,000 as £1,000 in interest has been charged. The following month, interest would be charged on the new balance, £101,000 meaning the interest for month 2 would be £1,010.
What are the related economics terms to simple interest?
There are several key terms that are closely related to simple interest. They are:
- Per diem interest – per diem interest refers to the interest charged on a loan or mortgage on a daily basis. Per diem interest can be charged on a simple or compound basis.
- Compound interest – while closely related to simple interest, compound interest is the opposite approach to charging or paying interest that is employed by financial institutions.
- Capitalised interest – capitalised interest is interest that is added to the balance of a loan. Capitalised interest can be either simple or compound.
For more details on loans, read our loan definition article.
What is the relationship between Simple Interest Mortgage and Simple Interest?
A simple interest mortgage is a type of mortgage that uses simple interest. In essence, simple interest mortgages are a product that uses simple interest.
