How To Calculate Simple Interest

Simple interest is the growth of money over a period of time.  The growth may represent money earning interest in an investment account or a loan accruing interest that you will pay in addition to principal.  The calculation of simple interest is straight forward and is a powerful tool that will help you keep track of your finances.

The simple interest formula is, I = Prt. In this formula, I is the amount of interest earned in dollars, P is the principal or initial amount of money of the loan or investment, r is the interest rate expressed as a decimal, and t is the number of time periods over which the interest is earned, this unit is typically expressed in terms of years.

The simple interest formula is applied to calculate interest earned in investments or interest owed in loans.  An example will make this concept clearer.

Let’s say that George has $4,000 in a money market account at XYZ bank.  He earns an interest rate of 2.5% over two one year periods.  He keeps this money in the account unchanged over this time period.  How much does he earn in interest for the two years?  In this situation our Principal, P, is $4,000, the rate, r is 0.025 (2.5%/100), the time, t is 2 years, and the interest, I, is what we are solving for.

So now we just apply the simple interest formula, I = Prt, to the situation in our example.  This gives us: I = ($4,000)(0.025)( 2yr), so the total interest earned, I = $200.  If we break this value down over the 2 years, we see that each year George earned $200/2 = $100 in interest.

Simple interest corresponds to a specific rate of return based on the principal for a specified period of time.  In other words, the rate and time period will remain constant and only a change in the principal will increase the interest earned or owed over the time period.  Compound interest is a similar yet a little different.  In the calculation of compound interest, there is also a specific interest rate associated and time period, but the amount in earned interest each year will increase after the first, even as the principal remains unchanged.  This increase in interest earned or owed occurs as the yearly earned interest is added to the principal and interest is calculated for that new amount.  In the calculation of simple interest the yearly earned interest is not added back to the principal resulting in earned or owed interest that does not change unless the principal does.  For obvious reasons, it is highly favorable to have loan interest calculated as simple interest.

RESOURCE:

Bittenger, Marvin L., Keedy, Mervin L., & Ellebogen, David (1994). Intermediate Algebra, Concepts and Applications (4th ed.). USA: Addison-Wesley Publishing Company.