Simple interest

Before you rely on it

What to check

Ask which one the loan actually uses.

The common error

Where people go wrong with simple interest

Taking the phrase at face value. Ask how interest is calculated, not what the product is called.

Worked through

Simple interest in plain numbers

Lend $5,000 at 4% simple interest for three years. Interest is principal × rate × time: $5,000 × 0.04 × 3, or $600. You are owed $5,600 at the end, and the interest is the same each year, $200; compare compound interest at the same rate: $5,000 × 1.04³ is $5,624.32, so the interest is $624.32, about $24 more. Over one year the two are identical. The gap opens with time and rate. Some car loans and short-term notes use simple interest computed on the outstanding balance each day, which is a different matter from a flat rate applied to the original principal.

Easily confused

Simple interest and its neighbours

Simple interest is not compound interest. Simple interest is calculated only on the original principal. Compound interest adds earned interest to the base, so it earns interest on interest. Nor is it the same as an amortized loan, though some amortized loans compute interest daily on the balance using a simple-interest method; a flat-rate loan charges interest on the original amount for the whole term even as you repay, so its true APR is much higher than the flat rate suggests.

In real decisions

Where simple interest turns up

Short-term loans, some bonds, treasury bills, car loans and certain personal notes use simple-interest calculations; students meet it first in math classes as the formula I = Prt; it is handy for quick estimates, such as the cost of a 90-day loan. Lenders in some places must show the APR when the quoted rate is a flat rate. Comparing it with compound interest shows how much the frequency matters.

Know the edges

Where simple interest stops being reliable

For longer periods, simple interest understates what growth or debt does, since most real accounts compound. Day-count conventions change the result slightly. Check whether a quoted rate is simple, flat or compound, and convert to APR to compare offers; read the loan terms to see how interest is actually calculated.

Quick answers

What people ask about simple interest

How do I calculate simple interest? Multiply principal by the rate and the time in years. $5,000 at 4% for 3 years earns 5,000 × 0.04 × 3, or $600.

Where is simple interest used? Short-term loans, some car loans, treasury bills and certain notes. Always check whether interest is calculated on the original amount or the declining balance.

Is a flat rate the same as simple interest? Not in effect. A flat rate applies interest to the original amount for the whole term, even as you repay, so its true APR is much higher.

Can simple interest be daily? Yes. Some loans accrue simple interest each day on the outstanding balance, so paying early reduces the interest. Check whether your loan works this way.