Simple Interest

Simple interest is calculated exclusively on the original principal (the initial amount invested or borrowed), ignoring any interest that has already accumulated. The formula is straightforward: Interest = Principal × Rate × Time. A $10,000 investment earning 5% simple interest generates exactly $500 per year, every year, regardless of how long the money is invested. After 10 years, total interest is $5,000 (10 × $500), bringing the total to $15,000.

Simple interest contrasts sharply with compound interest, where earned interest is added to the principal and begins earning its own interest. The same $10,000 at 5% compound interest would grow to $16,289 after 10 years — $1,289 more than with simple interest. Over longer periods, the gap becomes enormous: after 30 years, simple interest produces $25,000 total while compound interest produces $43,219. This difference — $18,219 — represents the "interest on interest" that simple interest forfeits.

In practice, simple interest is relatively uncommon in investing but common in certain lending products. Auto loans, some personal loans, and Treasury bills use simple interest calculations. Most savings accounts, bonds, and investment returns use compound interest. Understanding the distinction matters when comparing financial products: a loan advertising "simple interest" is typically cheaper than one with compound interest at the same rate, while a savings account offering simple interest is less favorable than one offering compound interest. For investors, the critical insight is that compound interest — not simple interest — is the engine of long-term wealth creation, which is why reinvesting returns is so important.