What is simple interest and why would anyone want to calculate it? Secondly, what is interest at all?
What is Interest?
Interest is what you or I pay, or anyone, pays for borrowing money. It’s the cost of borrowing money. Simple interest always uses principal amount in the calculation which means the interest payment is the same for the lifetime of the loan. There is no interest on interest over any period of time. That is why it’s simple, and you’ll be glad to know that it’s a simple calculation.
Principal
Principal means the original amount of money borrowed. Don’t confuse principal balance with a principle or the principal at school. Principal is not the same as balance, we will dig into that more in the next post. For now, just know that principal means the original amount borrowed.
Simple Interest
To calculate the total when using simple interest all you need are 3 things: Principal, Interest Rate, and Time (Period). Some people, and websites I’ve seen, try to complicate this calculation. I won’t.
Before we look at examples, let’s name a few things:
SI = Simple Interest = Total Interest
P = Principal = Original Amount Borrowed
I* = Interest Rate = The Cost Of Borrowing
T = Time = Period
*It’s easiest to convert the interest into a decimal instead of a whole number. You can calculate either way, but using a whole number adds an extra step. For example, if the rate is 10%, use .1, or if you have 6.75% for the rate, use .0675. More on this at the end of the post.
The calculation is as follows: Simple Interest = Principal x Interest Rate x Time. More mathematically: PIT. That’s it! Commonly, you’ll see this formula written as Prt where r is the rate of interest. It works out the same, just remember the PIT method. Seriously, that’s all there is to it. Time to look at some examples.
Let’s take $1,000 with an interest rate of 10% for 1 year and calculate. This is what the calculations would look like one step at a time. Pay no attention to my amazing spreadsheet skills. In time, you’ll come to understand I have none.
There is no need to add any kind of parentheses since it is all multiplication, the order of operations works. If you need a refresher please check out Order of Operations.
Step-by-step
Let’s break this down step-by-step and then show another example.
First, we take the Principal of $1,000 and multiply it by 10% or .1 to get $100.
Second, we multiply the interest by the period. In this example the period is 1 year. So $100 * 1 = $100.
Done. In the last step for the total, we simply add the $100 in interest to the principal to identify the total amount paid or received.
Let’s take another example where you take out a loan for $1,500 at a rate of 12% for 3 years using simple interest.
First we take $1,500 and multiply by .12 (or 12%) for $180.
Next we take $180 and multiply that by 3 for the number of years. This step gives us $540: $180 * 3 = $540.
Lastly, we add $540 + $1,500 = $2,040.
See, that wasn’t so bad!
Extra Step Method
Earlier, I said this calculation works with whole numbers instead of decimals but requires an extra step. If you don’t know how to convert whole numbers to decimals, or just prefer to work with whole numbers, here’s the process.
Let’s calculate $1,200 borrowed at 10% for 1 year:
First, like always, we multiply $1,200 by 10 to get $12,000. Wait, what?!
Then we multiply $12,000 by the 1 year to get $12,000.
Next, the extra step, we have to divide the $12,000 by 100 to get $120.
Lastly, we then add the $120 to $1,200 to get $1,320.
It’s not horrible, but this is where I see people mess up a lot. I have also seen ridiculous things online like turning the PIT calculation in to a monstrosity such as
P * (I / 100) * T.
Still not bad. However, this intimidates people more because of the parentheses and makes it look more mathy than it should be.
Closing Thought
Simple interest is a very common for some savings accounts at a bank, personal loans, payday loans, student loans and even car loans. At its core, Simple interest is just that: simple. It does not take into account fees, payments, or anything else. Many other calculations come from Simple interest, which makes it the perfect place to start.