WHAT IS SIMPLE INTEREST?
Imagine borrowing $100 from a friend at a 10% annual interest rate for a year. Simple interest means you’ll only pay interest on the initial $100, not on any accumulated interest. So, after a year, you’ll owe your friend $110: $100 (principal) + $10 (interest).
• Unlike compound interest, which grows exponentially, simple interest accumulates linearly. The interest amount remains constant throughout the investment/loan period.
• Whether the interest is calculated monthly, quarterly, or annually, the total amount earned/charged remains the same as long as the total time period and interest rate are fixed.
Formula
SI = PRT
• SI is the simple interest earned/charged.
• P is the principal amount.
• R is the annual interest rate (converted to a decimal if given as a percentage).
• T is the time period (in years).
For example, let’s calculate the simple interest for a loan of $5,000 at 5% interest for 2 years
SI = $5,000 * 0.05 * 2 = $500
Therefore, after two years, you’ll owe a total of $5,500 ($5,000 principal + $500 interest).
APPLICATIONS OF SIMPLE INTEREST
Simple interest plays a crucial role in various financial scenarios
• Savings Accounts: Most traditional savings accounts offer simple interest on your deposited amount.
• Short-Term Loans: Payday loans and some personal loans often use simple interest calculations.
• Bonds: Some bonds pay a fixed interest rate at regular intervals, essentially employing simple interest principles.
• Present Value and Future Value Calculations: Simple interest forms the foundation for understanding more complex financial concepts like present value and future value.
