Calculating Interest 1: Simple Interest

When you’re investing (or borrowing) money and someone gives you an interest rate, what does that rate mean? Is a higher number always better (or lower number if you’re borrowing)?

This is a series on different ways to calculate interest, starting very simply, with simple interest.

Simple interest means that the principal is the only thing that creates interest. But that interest doesn’t create more interest.

For example, you invest $10K at 5% simple interest. Each year you’ll get 5% of the $10K, which is $500. The $10K never grows or shrinks. It just continues to produce $500 each year until the $10K is given back to you.

That’s it. Your principal (the $10K) creates interest each year ($500). But that interest ($500) is distributed to you, so it doesn’t create more interest.

If you’re borrowing money, simple interest is usually called an interest-only loan. You borrow $10K at 5% simple interest. Each year you’ll pay 5% of the $10K, which is $500. The $10K never grows or shrinks. You just need to pay the $500 each year until you pay the $10K back.

Here’s the formula: Total Interest = Principal x Rate x Time. If the examples above lasted 10 years, the total interest would be $5K. $10K x 5% x 10yrs = $5K.

What do you think?
Joseph

This is a series. Here is the next post.