Simple interest

What it means

Simple interest is a method of calculating interest in which interest is always charged only on the original principal. Interest credited in earlier periods is not added to the principal and earns no further interest itself, so the amount owed grows in a straight line, at the same pace in every period.

The calculation is straightforward: interest equals the principal multiplied by the annual interest rate and by the number of days divided by the length of the year. With a principal of 10,000 euros, a rate of 6% and 90 days on a 360-day basis, interest comes to 150 euros, however often it is paid.

The opposite is compound interest, where interest is added to the principal and earns interest in the next period. Over short periods the difference is negligible, but over several years compounding leads to a noticeably higher amount, as the time value of money explains.

How it works in practice

Simple interest is used mainly for short-term deposits, for calculating late payment interest and for loans between companies or from a shareholder. In commercial relationships late payment interest is the ECB main rate plus 9 percentage points, always charged on the outstanding principal only.

For a shareholder loan or an intra-group loan, the contract should state the rate, the day-count convention and the interest method clearly. If the parties are related, the rate should reflect market terms under the transfer pricing rules.

In the books interest is accrued: at the end of the period the interest belonging to that year is recorded even if it will be paid later. With simple interest this is easy, just interest on the principal for the number of days to the year end, with no need to recompute credited interest.

What to watch out for

The nominal rate under simple interest may not reflect the true cost. If interest is paid in advance or fees are added to the loan, the real cost is higher. To compare offers, use the effective interest rate or, for consumers, the APRC.

In long-term contracts, check whether interest is charged on interest. Civil law limits capitalisation of interest, and for consumers a clause providing for interest on interest may be an unfair term. In business relationships the wording of the contract decides.