Simple interest is a fee paid by a borrower to the lender for the privilege of using his money. This fee is a percentage of the loan amount. Simple interest can be paid to a lender by a person who took out a loan, or paid to a person depositing money into a bank account. When you deposit money into a bank, you are essentially loaning it to the bank. Simple interest is the amount initially charged on a loan, and does not take into account the compounding of interest over time.
Simple interest can be identified by a simple math formula. The principal amount of the loan is multiplied by the rate of interest paid per year. That total is then multiplied by the number of years of the loan. The result is the simple interest. Simple interest is usually stated as an annualized percentage rate. This is the amount of interest that would be paid over 1 year, even if the term is shorter or longer.
Simple interest does not consider the interest charged on interest. When a bank pays interest on a savings account, the amount in that account increases. If that interest is left in the account, there will be a larger amount for the bank to pay interest on the next time. This is called compound interest. The amount the account actually accumulates over the course of a year after interest is compounded several times is called the annual percentage yield. Simple interest is the percentage calculated each time, not the amount actually accrued.
There are several things to consider when comparing various bank accounts or loans paying simple interest. The term is just as important as the interest rate. A savings account that pays 2 percent every 6 months is not the same as one that pays 4 percent every year. This is because the 6-month account would compound once during that year. It is also important to consider whether the interest is paid separately from the account or added into the account. If the interest is kept separate, it is simple interest. If the interest is added to the account, it is compound interest.
Simple interest is sometimes used for very short-term loans. For example, simple interest can be charged for a period of 30 days when the short-term loan is promised to be repaid. The repayment amount is the principal loan plus the simple interest. Since the period of time is so short, the interest is not compounded.
Some mortgages are offered with simple interest. They are identical to traditional mortgages except for the frequency with which the interest is calculated. Simple-interest mortgages calculate interest every day, while traditional mortgages do it once per month. Simple-interest mortgages benefit people who want to pay off their mortgages early. When mortgage payments are made more frequently and for greater amounts, the simple interest is calculated on a smaller mortgage balance. Simple-interest mortgages are bad for people who wait until the last minute to make their mortgage payment and need all month to gather the money. Since interest is calculated every day, they end up paying more in interest.