Simple Interest

With simple interest, the interest each period is always the same, because it is always based on the original principal. It does not grow over time.

Suppose you save 5,000 at a simple interest rate of 4% a year. Each year you earn 200, which is 4% of 5,000. After three years you have earned 600 in interest, and your balance is 5,600. The fourth year earns another 200, no more.

This makes simple interest easy to calculate: multiply the principal by the annual rate and by the number of years. Here, 5,000 × 0.04 × 3 = 600.

Simple interest is common for short-term loans, some car loans and certain bonds that pay a fixed amount of interest each year. Most savings accounts, credit cards and long-term investments, however, use compound interest, where interest is added to the balance and then earns interest itself. Over long periods, the difference between the two can be very large.