Simple Interest

Simple Interest is just that...simple! Under a Simple Interest loan, interest is calculated in a way that "ignores the effects of compounding." What this means is that additional interest is not calculated on the interest that has already been accrued. Simple Interest loans are commonly made on a short-term basis or in relatively informal settings (such as loans between friends or family members).

To calculate, simply take the amount of money interest is being earned on (commonly called the Principal), and multiply it by the interest rate in decimal format.

For example: $100 at 5% (0.05 in decimal form) per year.

$100 x 0.05 = $5.

It really is just that easy.

Slightly more complex, we can determine the Simple Interest earned at less-than-year intervals. The formula becomes Principal x (Interest x [Time / Total Interval] ).

So, using our original example of $100 at 5% per year, we will shorten the time period to 6 out of 12 months.

1. $100 x ( 0.05 x [6/12] )
2. $100 x ( 0.05 x [1/2] )
3. $100 x (0.025) = $2.50

Now, let's apply it to a real life situation. I lent $1,000 to a friend for one year at 8% interest. However, given the significant interest, he decided to pay me early at 9 months. So, to calculate the total amount I was owed...

1. $1,000 x ( 0.08 x [9 / 12] )
2. $1,000 x (0.08 x [3 / 4] )
3. $1,000 x (0.06 ) = $60

I then take the $60 in interest and add it to the principal balance my friend borrowed.
4. $1,000 + $60 = $1,060.

Some may be thinking "I could never charge my friends interest!"

While the amount of interest earned may seem insignificant, it is enough to provide a gentle incentive to pay on time or, as in my case, early. Also, if my friend had decided he could not pay on time, it would help to protect my own finances by compensating me for the delay in repayment in the form of additional interest.