What is Simple Interest
Simple interest is a way to calculate the additional compensation due on the initial principal only. On the whole, the formula is a multiplication of the principal, the rate, and the time. Or simply,
Simple Interest ($) = Principal ($) x Interest Rate (%) x Time (Years)
Simple Interest ($): The compensation on the principal in return for the time spent
Principal ($): The initial amount of money involved in the situation
Interest Rate (%): A fixed percentage charged for the situation
Time (years): The period when the situation occur
I invested $100,000 at a rate of 10% for 6 years.
Simple Interest = $100,000 x 10% x 6 years = $60,000
Altogether, I will receive $100,000 + $60,000 = $160,000 at the end of 6 years for my investment.
I invested $100,000 at a rate of 10% for 6 months.
Simple Interest = $100,000 x 10% x 6/12 years = $5,000
All in all, I will receive $100,000 + $5,000 = $105,000 at the end of 6 months for my investment.
In this case, take note that I took 6 months / 12 months for the time period. This is because the formula works only when the unit for the time period is in years.
Real Life Application
As an illustration, I bought a secondhand car at $70,000. After a downpayment of $30,000, I took a 5 years loan on the remainder at a rate of 2.28% per annum.
Simple Interest = ($70,000 – $30,000) x 2.28% x 5 years = $4,560
In sum, I will pay a total of $70,000 + $4,560 = $74,560 for my secondhand car at the end of 5 years.
When we compute the returns using simple interest, its yield will always be smaller as compared to the returns generated by compound interest. This is because of the lack of compounding effect.
In the local context, we will often use simple interest for car loans. Accordingly, any early or on time repayment helps to reduce the principal loan at a faster rate. Thereupon, we will be able to complete the loan on an earlier than expected date. Likewise, if we were to make late payments each time, the final repayment will be larger than the original estimate.
In short, always make repayments on your loan on time! 😉
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