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What is a simple interest loan?
A simple interest loan is one in which the interest has been calculated by multiplying the principal (P) times the rate (r) times the number of time periods (t). The formula looks like this: I (interest) = P (principal) x r (rate) x t (time periods).
When borrowing money, the amount borrowed, called the principal, plus the interest, which is what the lender charges for loaning the money, must be repaid. The interest is usually expressed as a percentage of the borrowed amount. Simple interest is the most basic way of computing interest on a loan. In reality, interest — whether it’s being paid or earned — is calculated using different methods. The longer the term of a loan, the less accurate a simple interest calculation will be.
Making early payments or additional payments will reduce a loan’s principal balance and cut the total cost of interest paid over the life of the loan. Simple interest does not take into account compounding. Simple interest is significantly beneficial to borrowers who make prompt payments. Late payments are disadvantageous as more money will be directed toward the interest and less toward the principal.
Simple interest applies mostly to short-term loans, such as personal loans. A simple-interest mortgage charges daily interest instead of monthly interest. When the mortgage payment is made, it is first applied to the interest owed. Any money that’s left over is applied to the principal. Some lenders apply simple interest to mortgages with a biweekly payment plan. This payment method leads to interest savings because borrowers make two extra payments a year.
Knowing how to calculate simple interest gives a general idea of what a loan will cost or what an investment will return. It’s a good foundation to have before learning to calculate more complicated rates such as annual percentage yield, or APY.
Simple interest loan example
On a two-year loan of $20,000 with an annual interest rate of 8 percent, the simple interest is calculated as follows:
20,000 x .08 x 2 = $3,200
Therefore, the total amount owed will be $23,200: $20,000 for the principal and $3,200 for interest.