The term simple interest is used to describe a calculation involving the application of a rate to principal. Simple interest would be equal to the financing charge associated with the outstanding principal of a loan in one period of time.
Simple Interest = Principal x Rate x Time
Lenders charge borrowers a rate of interest as payment for the use of that money. The financing charge, or interest charge, is a function of the amount borrowed (outstanding principal), the length of time it is used (time), and the cost to borrow (interest rate). With an amortizing loan, the borrower repays a lender both the interest charges and principal.
Simple interest is calculated at a point in time, and is usually associated with loans. Compound interest is typically used by lenders when stating the interest earned on a deposit. For example, a bank might pay a simple interest rate of 5.000% and apply it daily to an account balance. This allows the bank to state the rate as 5.127%, compounded daily.
Lindsey borrows $1,000 from a family member, promising to repay the money owed in two years. The family member has agreed to lend her this money but is charging her 10% per year for its use. Lindsey would owe this family member a simple interest charge of:
= $1,000 x 10% per year x 2 years = $200
The total amount repaid would be:
= $1,000 (in principal) + $200 (simple interest), or $1,200