Understanding Simple Interest

Interest is the price of using money over time. When you borrow, interest is the extra you pay back on top of what you took. When you save or lend, interest is the extra you earn. Simple interest is the most basic kind, and it's a clear place to start.

Simple interest uses three things: the principal (the starting amount), the rate (a percent per year), and the time (in years). The formula is principal times rate times time. Say you borrow $1,000 at 5 percent per year for 2 years. That's 1,000 times 0.05 times 2, which equals $100 in interest. You would repay $1,100 in total.

Notice that simple interest is figured only on the original amount each year. In the example above, you pay $50 of interest the first year and $50 the second – always 5 percent of the same $1,000. The interest doesn't pile up on itself. That keeps the math easy and predictable.

Many real loans and savings accounts use compound interest instead, where interest gets added to the balance and then earns more interest. Over time, compounding usually grows faster than simple interest – good when you're saving, costly when you're borrowing. Knowing which one applies changes the true cost, so it's worth asking the lender or bank directly.

A helpful number on many loans is the APR – the annual percentage rate – because it tries to bundle the interest and certain fees into one yearly figure. A lower APR generally means a cheaper loan. When you compare two offers, compare their APRs over the same length of time, not just the monthly payment, since a smaller payment stretched over more years can quietly cost more.