Simple interest

Key Takeaways

• Simple interest is figured only on the original principal balance, so it ignores compounding entirely.
• The formula is principal times the annual rate times the time in years, so $10,000 at 6 percent for two years produces $1,200 of interest.
• Compound interest uses the same arithmetic except the balance grows each time interest is added, which is why compound totals run higher over the same term.
• Washington caps interest under RCW 19.52.020 at the higher of twelve percent per year or four percentage points above the 26 week treasury bill rate.

What It Means

Simple interest is the plainest way to price the use of money. Take the original principal, multiply by the annual rate, then multiply by the number of years the money is outstanding. Nothing is added back into the balance along the way, so the charge for year five is identical to the charge for year one. Principal times rate times time, and every real estate math question built on it follows from those three inputs.

An example makes it concrete. A $200,000 balance at 6 percent produces $12,000 of interest in a year, which is $1,000 a month. That monthly figure is why the concept shows up on a settlement statement: interest Proration at closing, per diem interest on a new loan, and the interest on a seller carryback note are all simple interest calculations.

Compound interest works the same way with one change. The balance itself grows each time interest is credited, so the next period is figured on a larger number, and over a long term that gap gets wide. Simple interest is also different from Amortization, where each level payment covers the interest due on the current balance and applies whatever is left to the loan balance. The rate, the compounding, and the payment terms all come from the Promissory Note, so read it rather than assuming.

How It Works in Washington

Washington's interest ceiling lives in RCW 19.52.020. Any rate of interest is legal so long as it does not exceed the higher of twelve percent per annum, or four percentage points above the equivalent coupon issue yield, as published by the Board of Governors of the Federal Reserve System, of the average bill rate for twenty-six week treasury bills. A rate above that ceiling runs into Washington's Usury rules, and the simple interest formula is how anyone checks a seller financed note against the cap before it is signed.

Simple interest also drives the numbers on a Washington closing statement. Mortgage interest is normally paid in arrears, so the settlement agent prorates the seller's unpaid interest through the closing date, and the new lender charges the buyer per diem interest from funding to the end of the month. Both figures are principal times rate times days divided by the day count the lender uses. Brokers do not set rates and do not opine on whether a note is usurious. Send rate questions to the lender and ceiling questions to a lawyer. For the market context behind the arithmetic, see our piece on interest rates and Washington home sales.

Example

Grace Nakamura sells a small rental in Spokane and carries back $85,000 of the price on a note at 8 percent simple interest, interest only, with the whole balance due in three years. Annual interest is $85,000 times 0.08, which is $6,800. Divide by 12 and the buyer, Owen Pratt, pays $566.67 a month, and every payment is identical because the $85,000 principal never moves.

Over the full three years Owen pays $20,400 in interest and then repays the $85,000, for $105,400 total. Had the same note compounded annually at 8 percent instead, the payoff at the end of year three would be about $107,076, roughly $1,676 more, and that gap widens fast on longer terms. Grace's 8 percent rate sits comfortably under the twelve percent floor of the RCW 19.52.020 ceiling, so the note is not at risk on that front. If Owen wants to pay early, whether that costs him anything depends on the note, which is the subject of our explainer on prepayment penalties.

Common Mistakes and Exam Traps

• Simple interest uses the original principal for every period. Compound interest recalculates on the new balance, so the two answers differ on any term longer than one period.
• Simple interest is not the same as an amortized payment. An amortized loan applies part of each level payment to principal, so the interest portion shrinks every month.
• Watch the time unit. The formula runs in years, so a question stated in months needs the months divided by 12 before you multiply.
• A per diem interest question is still a simple interest question. Multiply principal by the annual rate, divide by the day count the lender uses, then multiply by the number of days.