Americans owe trillions of dollars on loans: car loans, loans to pay the bills, student loans, emergency loans. Loans on loans.
But many don't understand how interest is charged on loans -- and how it can make them very costly. The interest calculation can be a bit complicated, in the case of compound interest. Or it can be pretty straightforward, if you're paying what's called simple interest.
Here's how simple interest works when you're paying off a loan.
How simple interest works
Loans aren't free.
As a borrower from a financial institution, you are not only required to return the full borrowed amount, the principal, but pay the cost of borrowing, interest. Think of interest as a fee the bank charges for lending you money.
Conversely, when you gain interest in a high-yield savings account, the bank is paying you a fee to use your money to lend out to people.
Simple interest is calculated purely on the initial amount borrowed or deposited. That's in contrast to compound interest, which is earned on the principal and the interest, too — piling interest on top of interest.
Calculating simple interest
To calculate simple interest, take the interest rate — which is annual — and multiply it by the principal. Then multiply again by the number of years.
It's just that simple.
Here's an example of how simple interest works:
Tom needs a new car, and needs an unsecured loan to cover the cost, which is $10,000.
His credit score is decent, so the bank approves him for a $10,000 loan, to be paid back within the loan period: two years’ time. He gets an interest rate of 8%.
Tom's interest for one year would be $800: his principal ($10,000) multipled by the interest rate (8%, or 0.08). His total interest is $1,600: $800 times two (the number of years). So, he'll need to repay a total of $11,600.
See for yourself how simple interest works. Use a car loan calculator that takes simple interest and a number of other factors into account.
Where do you pay simple interest?
You might also see simple interest on consumer loans. Some larger stores will let you finance household appliances with simple interest for periods of 12 to 24 months.
For example, you might buy a $300 vacuum cleaner in monthly installments, at 8% interest. In the end, you will pay a total of $324, in monthly payments of $27.
Simple interest on loans can be better for your finances than more expensive compound interest, which is charged on credit cards. Simple interest makes the debt more manageable.
That's why it's often recommended that consumers take out personal loans to pay down credit card debt.
Where else does simple interest show up?
Simple interest is often associated with certain investment vehicles, too. Some certificates of deposit use simple interest for their returns.
Take an investment of $100,000 in a one-year CD at 3% APY. After a year, the earnings amount to $3,000 in interest income.
With a six-month CD, the gain would amount to $1,500, because of the shorter time frame.
Now that you're armed with a better understanding of simple interest, you should feel more comfortable discussing loans with your bank.