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What is simple interest?
Simple interest is interest calculated on the principal portion of a loan or the original contribution to a savings account. Simple interest does not compound, meaning that an account holder will only gain interest on the principal, and a borrower will never have to pay interest on interest already accrued.
The formula for calculating simple interest is: Principal * Interest Rate * Term of the loan.
Loans rarely use the simple-interest calculation, but those that do are auto loans and short-term personal loans. A handful of mortgages also use this calculation, most notably the biweekly mortgage. One of the reasons that the biweekly mortgage helps borrowers pay their homes off quicker is that paying the interest more frequently accelerates the payoff date.
With simple-interest loans, the lender applies the payment to the month’s interest first; the remainder of the payment reduces the principal. Each month, the borrower pays the interest in full so that it never accrues. If she pays her loan late, she’ll have to pay more money to cover the additional interest and keep the loan’s specified payoff date. This contrasts with compound interest, which adds a portion of the old interest to the loan. The lender then calculates new interest on the old interest owed by the borrower.
Simple interest is also rare with savings accounts; most savings accounts use the compounding method to calculate interest.
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Simple interest example
Kara takes out a new short-term personal loan. The loan is a $20,000 auto loan with 3 percent interest for five years, meaning that she’ll owe $3,000 over the life of the loan: $20,000 x .03 x 5. Each month, $50 of her payment goes toward interest on the loan.