Americans owe trillions of dollars on loans: car loans, loans to pay the bills, student loans, emergency loans. Loans on loans.
But many don't understand how interest is charged on loans -- and can make them very costly. Dive into the profound difference between simple interest and compound interest, and how it works in your favor when you're paying off a loan.
What is simple interest?
Unfortunately, borrowing money is not free.
As a borrower from a financial institution, you are not only required to return the full borrowed amount, the principal, but pay the cost of borrowing, interest. Think of interest as a fee the bank charges you for lending you money.
Conversely, when you gain interest in a high-yield savings account, the bank is paying you a fee to use your money to lend out to people.
Simple interest in both cases refers to the most fundamental way interest can calculated. It gives a basic idea of how much a loan could cost or investment could return.
Simple interest is calculated purely on the initial amount borrowed or deposited. That's in contrast to compound interest, which is earned on the principal and the interest, too — piling interest on top of interest.
How to calculate simple interest
Tom needs a new car, and needs an unsecured loan to cover the cost. $10,000.
His credit score is good, so the bank approves him for a $10,000 loan, the principal, given he returns the money within the loan period: two years’ time. They charge an annual interest rate of 8%.
With simple interest, the interest you pay or receive each year is the interest rate — which is annual — times the principal. It’s just that simple.
Then, calculate your total interest by multiplying by the number of years that you’re carrying the loan or holding the deposit.
Completing the calculation, we would get $11,600 as the total that Tom needs to pay back. This means his simple interest owed is $1,600.
Tom could get competitive car loan interest rates by looking into companies like LendingTree which compare interest rates realtime.
There are also calculators that can help you calculate your car loan payments, taking simple interest and a number of other factors into account.
Where do you see simple interest in real life?
You might also see simple interest when taking out consumer loans. Some larger stores will let you finance household appliances with simple interest for periods up to 12-24 months’ payment.
For example, a $300 vacuum cleaner with an annual rate of 8% in monthly installments: with payments of $27 per month, in the end, you will pay a total sum of $324.
With car loans like above, even student loans, you often pay monthly. This translates to a portion of the payment covering the loan balance on a monthly basis, while the rest is directed toward covering the interest payment.
By reducing the outstanding loan balance every month, you reduce the payable interest, meaning, a greater portion of the monthly payment is directed toward principal repayment.
Frankly, simple interest on loans is a very good thing for your finances. In contrast to credit cards, which use compound interest, loans only calculate interest on the initial principal. This makes the debt more manageable.
That's why it can sometimes be recommended to take out a personal loan to pay down credit card debt.
Where do you see simple interest in investments?
Simple interest isn't just associated with loans, but certain investment vehicles as well. Some certificates of deposit use simple interest for gains.
Take an investment of $100,000, in a one-year CD at 3% APY for example. After a year the earnings amount to $3,000 in interest income.
With the same interest rate for a period of only six months, gains would amount to $1,500 because of the shorter time frame.
Now that you're armed with a better understanding of simple interest, you should feel more comfortable discussing loans with your bank!