Understanding Simple Interest

When you make a payment on a simple interest loan, the payment first goes toward that month’s interest, and the remainder goes toward the principal. Each month’s interest is paid in full so it never accrues. In contrast, compound interest adds some of the monthly interest back onto the loan; in each succeeding month, you pay new interest on old interest.

To understand how simple interest works, consider an automobile loan that has a $ 15,000 principal balance and an annual 5% simple interest rate. If your payment is due on May 1 and you pay it precisely on the due date, the finance company calculates your interest on the 30 days in April. Your interest for 30 days is $ 61.64 under this scenario. However, if you make the payment on April 21, the finance company charges you interest for only 20 days in April, dropping your interest payment to $ 41.09, a $ 20 savings.

Key Points

  • Simple interest is calculated by multiplying the daily interest rate by the principal, by the number of days that elapse between payments.
  • Simple interest benefits consumers who pay their loans on time or early each month.
  • Auto loans and short-term personal loans are usually simple interest loans.