Simple interest is calculated based on just the outstanding principal balance of a loan. The amount of interest owed under this method can be calculated by multiplying the outstanding principal by the daily interest rate by the number of days between payments. The formula is:
(Outstanding principal) x (Daily interest rate) x (Number of days between payments) = Simple interest amount
For example, there is a loan outstanding of $10,000, there are 30 days between payments, and the daily interest rate is 0.0002. The simple interest calculation is:
$10,000 Principal x .0002 Interest rate x 30 Days = $60 Interest
Under this arrangement, each borrower payment is first applied to the outstanding interest, so that the interest is paid off and the remainder is used to pay down the remaining loan balance. This approach to calculating interest is most beneficial to borrowers who pay early, since there is less interest to pay, with a larger proportion of the payment being used to pay down the outstanding principal balance. Conversely, if a payment is late, a larger proportion of the loan payment goes toward paying off the interest, leaving a larger residual loan balance outstanding. The simple interest method is most commonly applied to very short-term loans.
A different calculation approach is used for compound interest, where interest is calculated based on the outstanding principal balance of a loan and accumulated interest.