How To Calculate Simple Interest (With Examples)

Calculating simple interest is a staple in an adult’s basic financial skills toolbox. The formula and solving for interest is straightforward and it’s useful for a bunch of complex fiscal situations that a person comes across in their lifetime.

Understanding how to find simple interest and its use in the world helps to navigate the often confusing nature of finances.

What Is Simple Interest?

Many big purchases as an adult are acquired through forms of loans. It’s rare for someone to have $250,000 sitting around in cash for a house, but most can pay this amount down over time based on the income they’re predicted to make.

When someone takes out a loan to make a purchase, they’re charged a percentage fee that represents the amount they must pay for borrowing the money.

This percentage fee, or borrowing amount, is the interest.

Simple interest is the most basic way to calculate this. It multiplies the original amount of the loan, which is called the principal, by a specified percentage to arrive at the amount of total interest due over time.

This form of calculating interest in a business is not commonly used because it’s not as comprehensive as compound interest.

The Difference Between Simple and Compound Interest

Compound interest is used more frequently in most real-world scenarios. It creates a tally of money owned, earned, or otherwise accrued through an interest rate that multiplies by the principal amount plus the previous period’s interest amount.

Over time, this results in more interest being acquired.

Alternatively, simple interest doesn’t change over time to reflect an amount growing slightly larger each month. It’s a one-time calculation done against the principal of an investment or loan to determine a total amount of interest payable.

When Interest Is Used in the Real World

Many scenarios use variations of interest rates in the real world. Below are a few examples:

1. An interest-earning savings account. While interest is often associated with the cost of taking out a loan, it also refers to the amount earned in certain situations, like an interest-earning savings account.

   This type of account earns the holder interest at a specified rate that accrues based on the amount of money they deposit over time.

   Banks usually compete with each other to give their account holders the best possible APY, or annual percentage yield, which represents the amount of interest that they have the potential to earn.

   Interest-earnings savings and similar accounts are an attractive option to financial planners because it allows them the chance to make more money by doing practically nothing aside from putting their cash in the bank.

2. Car loans. Car loans are another big reason that interest comes into play. A vehicle is a large purchase that requires most people to secure financing before the investment.

   When a borrower allows the purchaser to buy something, like a car, they charge a specified interest amount to be paid in congruence with the principal.

   A few factors that influence an individual’s interest rate on a car loan include:

   • Credit score

   • Annual net income

   • Debt to asset ratio

   • The amount the loan is for

   • How long it’ll take to pay back

   A person’s interest rate changes drastically depending on their details in these areas. Credit score and annual income have a particularly large influence on the average interest rate offered.

3. Credit cards. Interest racked up on credit cards often sneaks up on people who are unsure of how it works. Credit cards offer clients a line of credit that they can use to purchase items immediately, and then pay back later.

   An interest rate called an APR or annual percentage rate is charged to the amount of the credit line used.

   Similar to the interest rates applied to car loans, a credit card’s APR differs depending on the borrower’s financial information. The average credit card holder’s APR is around 16%.

   However, this percentage can go as high as 35% when the applicant has a poor credit history.

How to Calculate Simple Interest

As the name suggests, calculating simple interest is much easier than handling a compound equation. Getting the procedure for a simple interest down pat makes learning about complex formulas less intimidating.

Below are the steps for how to calculate simple interest:

1. Examine the formula. As with any mathematical equation, the beginning step is to take a good look at the formula. Getting familiar with the formula works towards the goal of understanding how to solve it. For calculating simple interest, the formula is as follows:

   A = P(1+rt)

   It appears initially as “1” sandwiched between a scrabble of random letters, but it’s a matter of plugging and solving once you understand what each variable stands for. Below is a definition for each part of the formula:

   • A= Total Accrued Amount

   • P= Principal Amount

   • r= Interest Rate

   • t= Time Period

2. Determine the variables. Every situation that requires the simple interest formula provides the solver with a series of variables to input in each position.

   • The principal amount is the barebones of a sum borrowed or invested before interest is taken into account.

   • The interest rate refers to the percentage of the principal that will be accrued over time additionally.

   • The time period is the term length of the agreement

   Consider the example of a woman named Julie who wants to finance a new car:

   A 2021 Volvo S60 caught her eye, which runs a price tag of $38,950. Julie decided to apply for an auto loan, which quotes her an interest rate of 7% over 5 years. She wants to know the total amount that she’ll have to pay with this loan offer.

   In Julie’s case, the corresponding spot for each variable is:

   • P = $38,950

   • r= 7%

   • t= 5 years

3. Convert the percentage to a decimal and input the variables. Since an interest rate is introduced as a percentage, it must first be converted to a decimal for the formula to be solved properly.

   To convert a percentage into a decimal, divide the original value by 100. The remaining number is the decimal version of the percentage.

   Once the decimal conversion is complete, the remaining numbers can be plugged into their appropriate place in the simple interest formula.

   In Julie’s car loan example, she was offered an interest rate of 7%. To turn this into a decimal, she divides 7 by 100. The result is 0.07.

   Now, she has all the information that she needs about defining variables to place them in the formula. As a reminder, the simple interest formula is A = P(1+rt). After entering the values associated with her car loan, the formula will look like the example below.

   A = 38,950 (1+(0.07)(5))

4. Multiply the interest rate by the amount of time. Solving a mathematical equation must be done in the proper order. Since the multiplication between the interest rate and the total amount of time resides in the innermost parentheses, this is solved first.

   When Julie multiplies her converted decimal interest rate by the 5-year loan term, the result is 0.35. This is resulting value is placed in the equation, making it now look like this: A = 38,950 (1+0.35)

5. Add 1 to the result. The next part of the simple interest formula is just a bit of basic addition. Add 1 to the result of the previous multiplication to arrive at a whole number.

   In the example, 1 would be added to 0.35 to get 1.35 This is put in the parentheses to create a new equation that looks like this: A = 38,950 (1.35)

6. Multiply the addition result to the principal. The equation is nearly complete now, and all that’s left to do is multiply the remaining values. This final answer represents the total accrued amount. That is the total amount due or earned with simple interest applied.

   In terms of Julie’s car loan, she finishes solving her simple interest equation by multiplying 38,950 by 1.35. The final outcome is 52,582.50.

   This number constitutes the amount that she’ll have to repay in total for the car loan, including interest accrued over the five-year term.

   Over the five years that she’s paying back her car loan, she’ll pay a total of $13,632.50 in interest in addition to the principal amount.

An Example of Calculating Simple Interest

With an example of interest on a car loan fresh in mind, let’s break down another common financial situation that requires simple interest calculation such as a savings account that earns interest over time.

Mark wants to set up a savings account that earns interest over time. Atlantic Capital Bank provides a savings account for their clients that returns a 1% interest rate.

He decides to use a simple interest formula to determine exactly how much this will impact his account over the next 10 years if he invests a principal amount of $1,500.

To begin, Mark determines where the variables of his situation should go in the equation. Below are his calculations for the definition of each variable:

• P = 1,500

• r= 1%

• t= 10

Before continuing any further, Mark realizes that he must transform his interest rate into a decimal. He divides 1 by 100 to arrive at a usable decimal value of 0.01.

With each value’s corresponding place and form figured out, he puts it together in the structured formula. It looks like this: A = 1,500 (1+(0.01)(10)).

Now, he can begin solving. He starts by multiplying the interest decimal of 0.01 by the amount of total time elapsed, 10 years. The resulting value is 0.1. The updated equation looks like this:
A = 1,500 (1+0.1).

Mark adds one to the result of the multiplication to get 1.1. The last thing he needs to do is multiply this by the original principal amount invested of $1,500. The result of this multiplication is $1,515.

This means that if Mark invests $1,500 into the savings account and does nothing else for 10 years, he will have earned $15 in accumulated interest.

Author

Sky Ariella

Sky Ariella is a professional freelance writer, originally from New York. She has been featured on websites and online magazines covering topics in career, travel, and lifestyle. She received her BA in psychology from Hunter College.