What does simple interest apply to?

Simple interest applies specifically to the original amount of a loan or account balance, known as the principal. This type of interest calculation is straightforward, as it is determined by multiplying the principal amount by the interest rate and the time period for which the money is borrowed or invested.

For instance, if you borrow $1,000 at an interest rate of 5% per year for 3 years, the simple interest would be calculated on the initial $1,000 each year, resulting in $150 in total interest. This illustrates how simple interest does not take into account previously accrued interest on that principal, which contrasts with compound interest, where interest is calculated on both the principal and any interest that has been added to it.

By focusing on the principal amount, simple interest provides a clear and easy-to-understand method for calculating the cost of borrowing or the return on an investment without the complexities of compounded interest. This reinforces the notion that when considering loans or savings accounts, understanding the distinction of simple interest originating solely from the principal is crucial for financial literacy.