What is simple interest and how does it work?

Interest can take many forms, depending on whether you’re borrowing or investing. When it comes to loans, interest is the price of borrowing money. And it’s often expressed as a percentage.

Simple interest means interest will be charged only on the original amount borrowed. Lenders may use simple interest for things like personal loans, auto loans, mortgages and more. Keep reading to learn more about simple interest and how it’s calculated.

What you’ll learn:

• Simple interest is a type of interest lenders charge to loan money. 
• Simple interest has a fixed rate and is based on the principal amount borrowed and the loan term.
• Compound interest is another type of interest. It is calculated based on the principal and interest that’s been charged or accrued.
• Loans that might use simple interest include payday loans, personal loans, auto loans, student loans and mortgages.

According to the Consumer Financial Protection Bureau (CFPB), interest is the price borrowers pay for borrowing money. But there are different types of interest and ways of calculating it. 

Simple interest uses a fixed rate to determine the amount of interest owed or accumulated. And when it comes to borrowing money, the amount of simple interest charged is based on:

• The principal, or original loan amount borrowed 
• The loan term, or how long you have to repay the loan in full

Simple interest may be calculated on either a daily or monthly basis. And lenders calculate the amount of simple interest owed by looking at the borrower’s outstanding balance on the day payment is due. 

When it comes to a loan with simple interest, the CFPB says that if you tend to pay more than your minimum amount due each month, your principal amount owed will get smaller over time as you continue making payments. 

The main difference between simple interest and compound interest is that simple interest is calculated using only the principal amount borrowed, invested or saved. Compound interest is calculated using both the principal and any accumulated interest. 

In general, interest accumulates faster in compound interest calculations. 

A simple interest rate and annual percentage rate (APR) are both expressed as percentages and can give an idea of how much it costs to borrow money. 

The main difference between the two is that an APR includes more than just the interest on a loan. An APR also includes any additional costs or fees the lender may charge, like origination fees. And in the case of mortgages, APR can also include:

• Mortgage points
• Closing costs
• Mortgage broker fees

You might be wondering how all this looks in action. Here’s how a simple interest formula works when borrowing money:

So to get the total amount of simple interest, you take the principal and multiply it by the interest rate and the loan term.

Here’s how that might look for an auto loan:

$40,000 (principal) x 0.06 (6% annual interest rate) x 6 (years of the loan term) = $14,400 total simple interest

Every loan has its own terms and rates. Loans that might use simple interest include:

• Mortgages
• Personal loans
• Auto loans
• Student loans
• Payday loans 

Simple interest refers to a type of interest rate that only applies to the principal amount saved, borrowed or invested. Unlike compound interest, there is no interest on top of the interest. And unlike an APR, simple interest doesn’t include any additional fees like origination fees or mortgage points.

In general, simple interest typically results in lower interest overall, while compound interest generally yields more total interest accrued. 

If you’re looking for a credit card with a low introductory rate, you can compare cards from Capital One and check for pre-approved offers.