Americans owe billions of dollars in loans: auto loans, loans to pay bills, student loans, emergency loans. Loans on loans.
But many don’t understand how interest is charged on loans – and how that can make them very expensive. Calculating interest can be a bit complicated, in the case of compound interest. Or it can be quite simple, if you pay what is called simple interest.
Here’s how simple interest works when you pay off a loan.
How simple interest works
Loans are not free.
As a borrower from a financial institution, you are not only required to return the full amount borrowed, main, but pay the cost of the loan, interest. Think of interest as a fee the bank charges for lending you money.
Conversely, when you get interest in a high yield savings account, the bank pays you a fee for using your money to lend to people.
Simple interest is calculated only on the initial amount borrowed or deposited. This contrasts with compound interest, which is earned on principal and interest as well – stacking interest on interest.
Simple interest calculation
To calculate simple interest, take the interest rate – which is annual – and multiply it by the principal. Then multiply by the number of years again.
It’s as simple as that.
Here’s an example of how simple interest works:
Tom needs a new car and needs an unsecured loan to cover the cost, which is $ 10,000.
His credit score is correct, so the bank approves him for a loan of $ 10,000, to be repaid within the time limit: two years. He gets an interest rate of 8%.
Tom’s interest for one year would be $ 800: his principal ($ 10,000) multiplied by the interest rate (8%, or 0.08). Its total interest is $ 1,600: $ 800 times two (the number of years). He will therefore have to reimburse a total of $ 11,600.
See for yourself how simple interest works. Use an auto loan calculator that takes into account simple interest and a number of other factors.
Where do you pay simple interest?
Simple interest typically applies to auto loans, student loans, and even mortgages.
You might also see simple interest on consumer loans. Some department stores will allow you to finance household appliances with simple interest for periods of 12 to 24 months.
For example, you could buy a vacuum cleaner for $ 300 in monthly installments, at an interest rate of 8%. In the end, you’ll pay a total of $ 324, in monthly installments of $ 27.
The simple interest on loans can be better for your finances than the more expensive compound interest, which is charged on credit cards. Simple interest makes debt more manageable.
This is why it is often recommended that consumers take out personal loans to pay off their credit card debt.
Where else does simple interest appear?
Simple interest is also often associated with certain investment vehicles. Some certificates of deposit use simple interest for their returns.
Take a $ 100,000 investment in a one year CD at 3% APY. After one year, the earnings amount to $ 3,000 in interest income.
With a six-month CD, the payout would amount to $ 1,500, due to the shorter time frame.
Now that you are armed with a better understanding of simple interests, you should feel more comfortable discussing loans with your bank.