Simple interest
Simple Interest Explained
Usually implemented in loans, simple interest is a mechanism for banks and financial entities to charge a fee based on a client's principal. Though not limited to banks, it is most common because a fixed amount is charged per year. See how it differs from compound interest below.
It can be modeled by the following equation: Interest = P * R * N where the components are:
- P: Principal Amount
- R: Percentage or Rate (expressed as a decimal)
- N: Time (usually in years or months)
Example Question 1
Using the equation, let us calculate the interest on a principal of $2,500 invested at a rate of 8% per year for 4 years.
P $2500 R 0.08 N 4 Interest = 2500 * 0.08 * 4
Our answer is $800. If $2,500 was borrowed from an entity then $3,300 is owed and the bank profits $800.
Simple vs. Compound
TL;DR: Pay simple interest. Earn compound interest.
Compound interest is used for saving money and is powerful when compared to Simple. Compound interest is essentially interest on your interest. Ergo, an increasing amount of money is earned each year with Compound.
Let us examine exactly how much more is earned with compound than simple. The following tables show how much interest is earned (excluding principal).
| P | $10,000 |
| R | 5% (0.05) |
| N | 4 years |
| Simple | $2,000 |
| Compound | $2,155.06 |
Not too large a difference yet. Let's give it time.
| P | $10,000 |
| R | 5% (0.05) |
| N | 20 years |
| Simple | $10,000 |
| Compound | $16,532.98 |
In 20 years, simple interest will double your earnings but compound interest will almost triple (x2.65) what you invested (principal).
Ergo, you walk away with $20,000 with simple interest and $26,532.98 if compounding yearly after having invested $10,000 twenty years ago.