Simple Interest

Funds paid back in return for borrowing a principal amount

Simple interest formula

Simple Interest, I = P x R x T

Where:

  • P = Principle
  • R = Rate
  • T = Period

The period must be expressed in the same scope of time as the rate. If, for example, the interest is expressed in a yearly rate, such as in a 5% p.a. interest, then the period must also be expressed in years. Note that, sometimes, changes to interest may be expressed in basis points (BPS). It may be worthwhile to learn how to convert BPS into interest rates.

If the interest rate is expressed as an annual figure, but the relevant time period is less than a year, than the interest rate must be prorated as such. For example, if the interest rate is 8% per year, but the calculation in question calls for a quarterly interest rate, then the relevant interest rate is 2% per quarter. This 2% per quarter is equivalent to a simple interest rate of 8% per year. This is not the same, however, in the case of compounded interest.

 

Simple interest example

Mr. A plans to place his money in a certificate of deposit that matures in three months. The principal is $10,000 and 5% interest is earned annually. He wants to calculate how much interest he will earn in those three months.

I = $10,000 * 0.05/year * 3/12 of a year
I = $250

 

Common applications of simple interest

Simple interest calculations are commonly used in:

  1. Certificates of deposits maturing in a year or less. When an investor places money in certificates of deposits for two years or move, the first year interest may be added to the principle at the start of the second year, forming some pseudo-compound interest rate.
  2. Certain loans, such as a car loan or home mortgage, can be calculated and amortized by the number of payments to be made. In this case, interest is calculated using the simple method. Sometimes, these are laid out in a debt schedule.