| Simple interest does not take compounding into account, and is determined by multiplying the principal by the interest rate (per period) by the number of time periods. |
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| To calculate: Add up all the interest paid/payable in a period. Divide that by the principal at the beginning of the period. For example, on $ 100 (principal): |
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Credit card debt where $1/day is charged. 1/100 = 1%/day |
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Corporate bond where $3 is due after six months, and another $3 is due at year end. (3+3)/100 = 6%/year |
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Certificate of deposit (GIC) where $6 is paid at year end. 6/100 = 6%/year |
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| There are three problems with simple interest: |
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The time periods used for measurement can be different, making comparisons wrong. You cannot say the 1%/day credit card interest is 'equal' to a 365%/year GIC. |
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The time value of money means that $3 paid every six months hurts more than $6 paid only at year end. So you cannot 'equate' the 6% bond to the 6% GIC. |
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When interest is due, but not paid, it must be clear what happens. Does it remain 'interest payable', like the bond's $3 payment after six months? Or does it get added to the original principal, like the 1%/day on the credit card? Each time it is added to the principal, it 'compounds'. The interest, from that time forward, is calculated on that (now larger) principal. The more frequent the compounding, the faster the principal grows, and the greater the interest amount is. |
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| Simple interest can be managed as part of the receivables life-cycle using the CollectOne software suite. |
