Interest rate - simple

What is Simple Interest Rate?

Interest is the cost that the borrower has to pay back to the lander on top of the borrowed amount. Usually, it is shown as a percentage, and depending on how it is calculated and applied, it can be simple or compound interest. In the current article, we focus on simple interest in the context of the loans- what is it, and the formula for its calculation.

It is calculated based only on the principal and doesn’t include the compound interest. 

The formula for calculating simple interest

It is relatively easy to calculate a simple interest. The formula is simple: Interest = Principal × Interest Rate × Time (in years).

The result shows the total interest that has to be paid by the customer for the whole period of the loan. 

Here is an example: If the customer borrows USD 100,000 and the annual interest is 4% for 20 years, the calculation will be:

Amount of interest = 100 000 x 4% x 20, which equals 80,000. That will be the total interest customers will pay for the entire period. 

Simple interest vs. Compound interest

The simple interest is based on the principle, while compound interest is charged not only on the principal amount but also on the accumulated interest from previous periods. 

The compound interest can significantly increase the total borrowed amount when applied to long-term loans. 

Fixed vs. Variable Interest – what is better

What is the better option between fixed or variable interest rates depends on many different factors, including economic conditions, personal financial circumstances, and preferences. 

Fixed interest rate

For the fixed interest rates - the interest does not change until your debt is fully paid off or for a certain amount of time according to the contract. That gives some advantages like: 

Predictability of payments: The fixed interest rate gives stability and security that the payments will stay consistent throughout the contract. That helps for better budgeting. 

Long-term loan solution: For long-term loans such as a mortgage, a fixed interest rate can offer peace of mind over a long period, especially when interest rates are low when taking out the loan. 

Even in times of economic instability and rising interest rates, a fixed interest rate could give protection against increasing credit costs.

However, it is important to note that the lender could change the interest rate with advance notification. 

Variable interest rate

Variable interest rates may vary during the different periods of the contract. That happens depending on the parameters based on which the bank or financial institution calculates the interest. 

A change in the interest rate can lead to a change in the monthly installments.

During economic stability and a downward trend in interest rates, a variable interest rate can save money in the long run. If you choose a fixed interest rate of, for example, 5%, but after only a few years, the total interest rate is lower than that - you will find yourself at a disadvantage. However, the floating rate could allow you to go with the trend. 

In times of decreasing interest rates, it may make sense to refinance your loan if you have a fixed interest rate. However, this is a matter for further analysis. 

It is a good idea to consult financial consultants and analyze how each option fits your personal finance strategy and goals. 

Interest is a fundamental concept in finance that affects both borrowers and lenders. Understanding the way interest works is crucial for good financial literacy.