Simple interest is a basic formula for calculating how much interest to apply to a principal balance. The formula for simple interest is:
Simple Interest = Interest Rate x Principal Balance
How It Works (Example):
For example, let’s assume that John Doe puts $1,000 in his savings account. The bank pays 3% per year in interest. Using this information and the formula above, we can calculate how much interest he will earn in a year:
Simple Interest = 0.03 x $1,000 = $30
Why It Matters:
Simple interest is a handy, easy tool for estimating the interest earned or paid on a certain balance in one period. However, it does not consider the effects of compounding, which is the process of earning interest on principal plus interest that was earned earlier. This means it can dramatically understate the amount of interest earned or paid over time.
