Simple Interest

What is Simple Interest?

Simple interest can be defined as the interest which is calculated on the principal amount that is borrowed or invested by the person and it is calculated by multiplying the principal amount borrowed or invested by the time period for which interest is charged and the rate of interest. It can be implemented on a yearly, monthly and daily basis.

Formula

Simple Interest = (P x R x T)/100

Simple Interest

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For eg:
Source: Simple Interest (wallstreetmojo.com)

*whereby SI = Simple Interest

  • P= Principal
  • R= Rate of Interest
  • T= Time period

Examples

Let us consider the below example for a clearer understanding:

Example # 1

If Mr. A. borrows INR 10,000 from Mr. B. @ 8% for 5 years, then at the end of the 5th year, Mr. A has to pay:

SI = 10,000*8*5   = INR 400/100

The amount of INR 4000 is the Interest amount, which has to be paid in addition to the Principal amount of INR 10,000. Thus, the final Amount = INR 10,000 + INR 4000 = INR 14,000.

All the above-mentioned components play an important role in the arrival of the interest amount. If any of the component increases or decreases, it will have a direct impact on the final result.

It is usually applied to Short-term personal loans or Automobile loans, which generally have fixed time payment and not a very large amount of Principal to pay off. Simple interest is calculated on a daily basis; it is most beneficial for customers who make their loan payments on a fixed date/monthly basis.

Example # 2

Mr. Z. borrowed $12,000 at 10% (SI) and lent the same sum of money to Mr. P. @ 15%. What will be the gain after 5 years?

Since the rate of borrowing was 10% and the lending rate is 15%, the gain is actually 5% [15% – 10%] for 1 year. Thus, to arrive at the gain, this difference is used as the ROI.

Given that T = 5 years and P = $12,000, the amount gained = $12,000 * 5 * 5% = $3,000

Installment and Simple Interests

The concept of the installment is extensively used in the finance world. When an individual wants to purchase a product, it is possible the individual may not have sufficient money to buy immediately. However, they can spread out the payment schedule over a given time frame, i.e., make equal payments over the duration. Since installments are after a fixed interval, the lender is losing out on the opportunity of enhancing the money, which could have fetched him more returns had the entire payment made at the time of initiation.

To compensate for the same, when every installment is made, a component of interest is also included with the Principal money as the Time, Value of Money.

Let us consider the below example:

What is the annual installment to discharge a debt of $7,700 due in 5 years with an ROI of 5%?

The installment paid at the end of the 1st, 2nd, 3rd, 4th, and 5th year shall result in the Simple interest paid for 4, 3,2,1,0 years, respectively.

Let us start with the assumption that the downpayment is $1000.

At the end of 1st year, amount paid will be = $1000 + {(5*4*100)/100} = $1020

At the end of 2nd year, amount paid will be = $1000 + {(5*3*100)/100} = $1015

At the end of 3rd year, amount paid will be = $1000 + {(5*2*100)/100} = $1010

At the end of 4th year, amount paid will be = $1000 + {(5*1*100)/100} = $1005

At the end of 5th year, amount paid will be = $1000

Thus, total amount paid = 1020+1015+1010+1005+1000 = $5050

This implies that for an amount of $5050, the annual instalment is $1,000 and therefore, for $7,700 the annual instalment with the component of Simple Interest:

(1000 * 7700) / 5050 = $1,524.75

In certain circumstances, the interest will not necessarily be charged on a yearly basis but could be quarterly, monthly or even a daily basis.

Let us look into another example:

A person lends $10,000 to a Corporation by purchasing a bond from them. It is computed on a quarterly basis at 3 percent per quarter, and a cheque for the interest is sent across every quarter to all the bondholders. The bonds expire at the end of 5 years, and the final cheque includes the original principal plus interest earned during the last quarter. What is the interest for every quarter, and what will be the total interest earned over the 5-year life of the bonds?

Given that P=$10,000, ROI = 0.03 per quarter with a time frame of 5 years. As the time period is on a quarterly basis, we shall consider 5 years = 20 quarters. Thus, quarterly interest:

SI = $10,000 * 0.03 * 1 = $300 for every quarter. Therefore, interest for 20 quarters = $300 * 20 = $6,000

Simple Interest vs Compound Interest

The concept of compound interest is used synonymously with Simple interest since it is a more accurate description of the interest amount earned. Let us study some of the differences between simple vs compound interestSimple Vs Compound InterestSimple interest is calculated on principal amount that is borrowed or invested by a person. Whereas compound interest is calculated on the sum total of principal amount and previous period’s accumulated interests.read more:

SICI
It is the interest amount computed as a fixed percentage of the Principal Amount.Interest amounts as a percentage of the principal amount and the accumulated interest. It’s like Interest on Interest.
The returns computed are lessReturns are on the higher side
The principal remains constantThe principal keeps on changing during the duration of borrowing. The amount keeps on accumulating.
Formula  = [P*R*T / 100]Formula = P*[1+r]t
Payment first goes towards the interest component and remainder on the principalSome of the monthly interest is added back to the loan for every succeeding month. Interest is paid on the old interest.
This is charged on the Principal amount.Compound Interest is imposed on the Principal and the Accumulated Interest
this concept is utilized on Small term loans, automobile loans, etcCompound Interest conceptCompound Interest ConceptCompound Interest is the interest earned from the initial Principal & the previously accumulated Interest amount. This is also known as “Interest on Interest” & it is always higher than the Simple Interest. read more is used by Banks, Financial institutions on Deposits, etc.

Conclusion

Simple Interest is an easy and simple tool for estimation of the interest earned or paid on a given Principal amount for a given time frame. It does not take into consideration the impact of compounding (the process of earning interest on principal plus interest amount earner previously). This can understate the amount of interest earned or paid overtime.

I hope you liked the Simple Interest Guide and also the differences between Simple vs Compound Interest. You may also look at the below articles to learn Corporate Finance.

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