Simple interest is, well, simple. To calculate simple interest, you would multiply your interest rate by the balance that you owe. Any payment you make, in excess of the interest calculated for that period, is applied toward your balance or “principal.”
Let’s look at an example. Bob takes out a simple interest loan of $1,000, at 12% per year. If Bob makes one payment, at the end of the year, $120 in interest ($1,000 multiplied by 12%) will be subtracted from his payment before it is applied to what he actually owes. If he sends in $500, his balance will drop to $620 ($1,000 balance minus $380 applied to principal).
If Bob waits another full year to make a payment, he will owe $74.40 in interest. That’s his $620 balance multiplied by 12%. Whatever payment he makes will have $74.40 subtracted from it for interest, before it is applied to his balance.
That’s it! It’s that simple! Most auto loans, many mortgages, and most personal loans from credit unions use
simple interest. As you’ll see in a moment, these are far more preferable than loans that use compound interest.