TheStreet

There are two main types of interest that you'll have to pay when you borrow money to pay for something: compound interest or simple interest.

Simple interest, as it sounds, is the simplest and the easiest for determining how much extra you'll have to pay for your loan. You'll have to know how to calculate simple interest even if you take out a compound interest loan, because the simple interest is the basis on which the compound interest is calculated.

Remember, interest is essentially the price you pay for borrowing money, on top of paying back that money itself (called the "principal").

How Do You Calculate Simple Interest?

Simple interest is called simple merely because it is easy to calculate, because it is based on the simple calculation of the principal times the percentage of interest per year.

Here's the formula:

Simple Interest = Interest Rate x Principal Balance x time period.

Say you open a savings account for a kid. The bank plans to pay 2% interest per year on the deposit of $100.

Using the formula, we say: Simple Interest = 0.02 x $100 x 1. That's $2.

Similarly, if you deposit $500 for, say, 5 years, you'll still only be paid $10 per year if the bank only pays simple interest on the deposit.

Simple Interest Vs. Compound Interest

Simple interest is called simple because the amount of the principal -- the amount of the loan itself -- and the rate of interest, don't change over time. Compound interest, however, adds the interest payment to the principal, so the amount grows over time. For instance, with a compound interest loan, you wind up paying back a larger loan than you originally borrowed because the interest is calculated on the total amount of the loan plus the interest it accrues for the period you're financing it.

In other words, with a compound interested loan, the balance of your original amount borrowed grows over time. But with a simple interest loan, it doesn't.

For example, if a friend loans you $100 with a rate of 10% a year, the interest payments will be the same each year using simple interest, whether the friend wants to be repaid in one year or two years or five years, or however long the friend is willing to loan you $100 at 10% a year.

But with compound interest, if the friend loaned you $100 at 10% a year, the first year, you'd owe 10% on the principal. But the second year, you'd owe 10% on the principal plus the interest of the first year; the same for the third, fourth and fifth year.

The loan payment would look like this at one year: $10 = ($100 x 10% x 1).

But by the second year it would look add up higher: $11 = ($110 x 10% x 1).
 
And by the third year, it would look grow even higher: $12.10 = ($121 x 10% x 1).

So, you'd start out owing 10% on the principal of $100. But by the end of the fifth year, you'd owe 10% on $161.05.

 

What is a Simple Interest Loan?

But what is a simple interest loan? To start with, you know that when you borrow -- from a bank, or credit card, or other type of lender -- you have to pay back not only the principal (the amount you borrowed), but the interest (the price you pay for the loan). This is why banks pay interest on deposits: because a deposit in a bank is actually giving the bank funds for its business, and banks usually pay you interest for your allowing it to use your money.

You now know that compound interest -- the other standard way of calculating interest on a loan -- has you paying interest not only on your principal, but also on the interest accumulated over previous periods.

Banks and other lenders offer a number of loan products with simple interest, including some car loans. In a simple interest car loan -- often called "financing" -- your interest is calculated on your principal on a daily basis. Like with some other loans, your payments for your auto loan are first applied to your interest, and the remainder is applied to your principal balance. The interest amount is equal to the annual rate, like 3%, divided by 365 days. So, for example, if you took out a $20,000 loan with a 3% annual rate, your daily interest on the loan would be $1.64 ($20,000 x 0.03 = $600. $600 divided by 365 = $1.64).

Simple interest loans are paid back in equal, monthly installments that are determined when you receive the loan. That's why you have coupon books or electronic reminders of your monthly payment for the life of your auto loan.

Because a portion of the payment goes to pay off interest, and the rest pays down your principal, such loans amortize. When you first start paying on the loan, a greater amount of your payment goes toward the interest, because the interest is calculated off of the remaining principal - which is highest at the start of the loan. A smaller portion of your payment goes toward interest as the loan progresses, because while the interest rate remains the same, the principal is paid down over time, so the amount of interest is owed on a smaller principal.

So, let's go back to our $20,000 auto loan.

You have a $20,000 loan at 3% "financing" for four years. Your daily interest on your $20,000 loan is $1.64. So your monthly payment would be $429.16 for 4 years. About $50 of your first monthly payment will go toward paying the interest, while the remaining $379.16 would go toward paying down the principal. As the interest is principal is paid down, the amount paid toward interest also goes down. Paying late can incur a penalty, and more of your payment will go toward interest because the interest cost will have been accrued daily during the time you missed a payment. So paying late hurts not only your credit reputation, but also costs you more, even without a penalty.

Other simple interest loans include student loans, which use the 'simplified daily interest formula,' calculating interest only on the balance, rather than on previously accrued interest.

Mortgages also tend to be simple interest loans. It is important to know if the interest on your mortgage accrues daily or monthly. If the mortgage accrues daily, it is a simple interest loan. If it accrues monthly, it could be simple interest as well -- but it could also be a negative amortization loan, in which the payment is less than the actual interest owed.

Credit cards tend to not be simple interest loans. In fact, the majority of credit cards calculate compound interest on a balance, which is added to your balance, making your debt grow over time if you only pay the "minimum payment." And they tend to compound daily.

Generally speaking, you do better to borrow with a simple interest loan if you make your payments on time every month, and you're better off with compound interest whenever you invest.

Who Should Take Out a Simple Interest Loan?

The easiest loan to manage payments on is a simple interest loan, whether it be an auto loan or a mortgage. If you have a solid income, and have the discipline to make flat monthly payments to pay off both your principal and interest over time, your best way to borrow would be with a simple interest loan. It's easier both to budget your payments, and to see your loan paid off.