What it is
Interest is the cost of borrowing money and simple interest is one way to compute it. Simple interest allows for a relatively easy calculation since it only applies to the principal or original amount loaned.
This type of interest is straightforward since it doesn’t involve the effects of compounding.
To calculate simple interest, keep the following factors in mind:
1. The principal or the money you start with. For loans, this often refers to the amount being borrowed.
2. The interest rate or the basis for the amount you must pay on top of the principal. This is usually shown as a percentage of the loan.
3. The term or the length of time you have to pay back the loan plus interest.
Check out the formula below:
Simple interest = Principal amount x annual interest rate x loan term in years
Let’s say you borrowed P10,000 with a 6% annual simple interest. If you need to pay it back within 2 years, here’s how much you’ll end up paying in interest in total:
Simple interest = 10,000 x 6% x 2 = 1,200
You’ll pay a P1,200 interest on top of a P10,000 loan with simple interest. To compare, here’s how much you’ll pay for the same loan overall if the interest compounds every year:
Compound interest = Principal amount x (1 + interest rate)Term - Principal amount
Compound interest = 10,000 x (1 + 6%)2 – 10,000 = 1,236
In this scenario, your borrowing cost will be lower if the loan comes with simple interest instead of compound interest.
What it means for you
You’ll likely come across interest when you borrow or lend money. It’s also present when you open a bank account or invest in an asset that offers to grow your money through interest.
As a borrower, you’ll benefit from paying less on a loan if the interest is simple and not compounding. However, if you’re lending or investing money, you’ll earn more with compound interest over a simple one especially if the term is long.
That’s because simple interest only affects the principal amount. Through the power of compounding, interest applies to both the principal amount and any interest that it has previously collected.
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