In more detail
The formula is I = P × r × t, where P is the principal, r the yearly rate and t the time in years. Interest is never added to the balance to earn more interest, so the total grows in a straight line. It is used for short-term loans, many car loans and some bonds and notes, where interest accrues daily on the outstanding principal: principal × rate × days / 365. With such a loan, paying early in the month reduces interest because the balance is lower for more days.
Why it matters
For the same rate, simple interest costs a borrower less and earns a saver less than compound interest, and the gap widens with time. Knowing which one a product uses is needed to compare offers correctly.
Example
- $5,000 at 4% for 3 years earns
5,000 × 0.04 × 3= $600; compounded yearly, it would earn $624.32. - A $20,000 loan at 6% with daily simple interest accrues
20,000 × 0.06 × 30 / 365= $98.63 over a 30-day month.
Common confusion
Compound interest earns interest on interest; simple interest is always calculated on the original principal (or on the outstanding principal, for a loan).