What is Simple Interest?
Interest-only on the principle –> slow-growing
In short:
Simple interest is only the interest paid on an initial principal, this form of interest does not compound. Meaning after the first period the amount interest is being paid on stays the same. This form of interest, while certainly having real-world applications is not as common as compounding interest. It should be noted investments in the stock market benefit from compounding interest, not simple interest.
FORMULA:
What is interest?
In-depth:
Interest is the fee you pay for borrowing money over a given period of time. Normally interest is expressed as an annual value, ex. 7% annually, this means in one year you would pay 7% of the value of the money you are borrowing.
The reason interest is applied to borrowing money is a result of opportunity cost normally referred to as the time value of money. The interest could be taken as a representation of the value of time for a certain amount of money with respect to a lender. Another way of putting it would be how much do you have to pay someone to use their money for a certain period of time.
Who benefits?
Since interest is only paid on the initial amount, the consumer borrowing money via simple interest benefits most. This is because the amount they pay does not increase with time. For example, someone who borrows $5,000 for three years at 5% with the principal due at the end of the three years would have to only have to pay $750 for the use of the $5,000 for three years.
Compare the example above to what the scenario would look like if we changed our interest to compound. Borrowing $5,000 for three years at 5% interest with interest and principal due at the end of the three years would have to pay $788.13 in interest. In this comparison, the $38 difference might not seem big but with a longer time frame, the difference grows exponentially.
Real-world uses?
Simple interest might be the most common form of interest however there are certainly real-world uses of them. Examples below:
- Bonds, bonds pay what is called coupons, this is a fancy term for an interest payment. These are non-compounded payments, the interest is not reinvested as a result no compounding takes place.
- Auto loans
- Mortgages
Additional resources: calculate your investments growth via compound interest or learn about compound interest.