Table Of Contents
- Simple interest allows you to quickly determine how much interest you’ll earn from a savings account.
- You need to know your beginning balance, interest rate, and time period to calculate simple interest.
- The economy, inflation, and a bank’s appetite for deposits influence interest rates.
- Understanding interest helps you make more money from your savings.
What Is Simple Interest?
Simple interest is the quickest way to calculate the interest rate of a loan or savings account.
In the case of loans, simple interest is used to determine how much of your repayment goes toward the loan’s interest. Once the interest gets deducted, the rest of your repayment goes toward the loan’s principal. You pay the full interest each month, meaning it never accrues.
Simple interest works in the opposite direction for a savings account.
You receive an interest payment based on how much money you’ve saved. This payment has a fixed percentage.
The Formula For Calculating Simple Interest
You can calculate how much simple interest your account generates using the following formula:
I = P x R x T
The letters stand for the following:
- I = Interest
- P = Your Beginning Balance
- R = The Interest Rate
- T = Time in Years
How to Use the Simple Interest Formula To Calculate Interest On A Savings Account
Let’s look at an example of how to use the simple interest formula to calculate the interest you earn from a savings account.
We’ll assume you have $9,500 saved in your account. That account has an interest rate of 2.25% attached to it. You receive interest on your savings annually and want to know how much interest you get in five years.
With these figures, the formula produces the following result:
9,500 x 0.025 x 5 = $1,187.50
So, you earn $1,187.50 in interest for the year. To figure out how much interest you get per year, divide this number by five. That leaves you with a static simple interest of £237.50.
You can also break this number down.
For example, let’s say you want to know how much monthly interest your savings generate. You can divide your annual interest by 12 to get that figure. In our example, your savings earn almost $19.80 per month.
Try A Simple Interest Calculator
How Is Simple Interest Different From Compound Interest?
The main difference between simple and compound interest is that simple interest is a fixed percentage. Compound interest accrues, which means it’s added to the accumulated interest you’ve generated on your savings. For a loan, compound interest adds to your interest payments by requiring you to pay interest on interest.
You calculate compound interest using the following formula:
CI = P x (1 + r)t – P
The letters mean the following:
- CI = Compound Interest
- P = Principal Amount
- r = Annual Interest Rate
- t = Number of Years
Let’s try plugging the figures from above into that formula.
CI = 9,500 x (1 + 0.025)5 – 9,500
CI = $1.248.37
As you can see, the compound interest generated is slightly higher than the simple interest earned using the same figures. That’s because you earn interest on your interest. As such, a savings account with compound interest may be more attractive than one with simple interest.
The Factors That Affect Interest For A Savings Account
Several factors may affect the interest rate attached to your savings account. The level of influence each factor exerts varies. Consider the following when opening your account.
Factor No. 1 – The Economy
The state of the economy has a huge influence on your interest rate. Generally speaking, surges in demand for loans and credit result in banks increasing interest rates. A lack of demand leads to lower rates because the banks need to attract customers.
These changing rates often apply to savings accounts. If a bank raises the rates it attaches to loans, it may do the same for savings accounts. This also applies to decreasing rates.
How does the state of the economy apply?
A challenging economic situation means people have less money in their pockets. As a result, they turn to banks for loans, which increases demand. The banks raise interest rates to take advantage of this demand. Ironically, this makes it more difficult for some lenders to access loans.
People have more disposable money in a healthy economy. The demand for loans decreases, leading to interest rates following suit.
Factor No. 2 – Inflation
Inflation is closely tied to the state of the economy. It tends to balloon in a struggling economy and herald an increase in the prices of goods.
This situation leads to a higher cost of living, which leads to more people applying for loans and credit. Thus, we see the previously mentioned supply and demand economics occur.
A rise in inflation is typically accompanied by a rise in interest rates. When inflation is lower, interest rates are more attractive for lenders, though they may be less attractive to savers.
Factor No. 3 – The Bank’s Appetite For Deposits
Savings accounts are liquid accounts. In other words, they’re deposits of tangible cash kept in the bank. Your bank offers savings accounts to increase the liquid funds it has available. Consequently, every dollar you put into a savings account goes toward the cash pool that a bank can use to make loans.
That need for physical cash can be beneficial when choosing a savings account.
When a bank needs more cash deposits, it may raise the interest rates attached to its savings accounts. This makes the accounts more attractive, encouraging more people to open them. The bank gets access to funds and savers enjoy higher interest rates.
Banks conduct a balancing act here. They can’t offer more interest on a savings account that they apply to their loans. Otherwise, they lose money when offering savings accounts. The result is that you’ll generally find that the rates attached to savings accounts are lower than those for loans.
It’s Crucial To Understand Interest Rates
Knowing how much interest your savings generate allows you to make smarter financial decisions. By working out the interest for an account, you can determine if it’s right for you. Always check multiple options, running calculations on each, to see which account offers the best returns.
