Any time you make use of someone else's money, such as a bank, you have to pay interest for that use — whether you're buying a house, a car, or some other item you want. The same is true when someone else is using your money.
For example, when you buy a bond or deposit money in a money market account, you're paid interest for allowing the use of your money while it's on deposit.
The financial institution that has your money will likely combine your money with that of other depositors and loan it out to other people to make more interest than it's paying you. That's why when the interest rates you have to pay on loans are low, the interest rates you can earn on savings are even lower.
Banks actually use two types of interest calculations:
Simple interest
Simple interest is, maybe not surprisingly, simple to calculate. Here's the formula for calculating simple interest:
Principal x interest rate x n = interest
To show you how interest is calculated, assume someone deposited $10,000 in the bank in a money market account earning 3 percent (0.03) interest for 3 years. So, the interest earned over 3 years is $10,000 x .03 x 3 = $900.
Compound interest
Compound interest is computed on both the principal and any interest earned. You must calculate the interest each year and add it to the balance before you can calculate the next year's interest payment, which will be based on both the principal and interest earned.
Here's how you would calculate compound interest:
| Principal × interest rate | = interest for year one |
| (Principal + interest earned) × interest rate | = interest for year two |
| (Principal + interest earned) × interest rate | = interest for year three |
You repeat this calculation for all years of the deposit or loan. The one exception could be with a loan. If you pay the total interest due each month or year (depending on when your payments are due), there would be no interest to compound.
To show you how this impacts earnings, calculate the three-year deposit of $10,000 at 3 percent (0.03):
| $10,000 × .03 | = $300 — Year One interest |
| ($10,000 + 300) × .03 | = $309 — Year Two Interest |
| ($10,000 + 300 +309) × .03 | = $318.27 — Year Three Interest |
| Total Interest Earned | = $927.27 |
You can see that you'd earn an extra $27.27 during the first three years of that deposit if the interest is compounded. When working with much larger sums or higher interest rates for longer periods of time, compound interest can make a big difference in how much you earn or how much you pay on a loan.
Ideally, you want to find a savings account, certificate deposit, or other savings instrument that earns compound interest. But if you want to borrow money, look for a simple interest loan.
Also, not all accounts that earn compound interest are created equally. Watch carefully to see how frequently the interest is compounded. The preceding example shows a type of account for which interest is compounded annually. But if you can find an account where interest is compounded monthly, the interest you earn will be even higher.
Monthly compounding means that interest earned will be calculated each month and added to the principle each month before calculating the next month's interest, which results in a lot more interest than a bank that compounds interest just once a year.
FAQs
Simple interest is an interest charge that borrowers pay lenders for a loan. It is calculated using the principal only and does not include compounding interest.
How to explain interest rates to a dummy? ›
Interest rates are charges or rates applied to borrowed or invested funds, representing the cost or reward for using or providing capital. They are an essential tool for monetary policy, influencing economic growth, inflation, and employment rates.
What are the different types of simple interest? ›
Simple interest is of two types ordinary simple interest and exact simple interest. In ordinary simple interest, a year is considered of 365 days while calculating the interest while in exact simple interest, a year is considered 366 days if it is a leap year.
How to calculate interest for dummies? ›
For example, a five-year loan of $1,000 with simple interest of 5 percent per year would require $1,250 over the life of the loan ($1,000 principal and $250 in interest). You'd calculate the interest by multiplying the principal, the annual percentage rate (APR) and the length of the loan: $1,000 x 0.05 x 5.
What is simple interest for beginners? ›
Simple interest is calculated by finding a percentage of the principal (original) amount and multiplying by the time period of the investment. The final value of the investment can then be found by adding the simple interest to the principal amount.
How do you explain interest rates simply? ›
To put it simply, interest is the price you pay to borrow money — whether that's a student loan, a mortgage or a credit card. When you borrow money, you generally must pay back the original amount you borrowed, plus a certain percentage of the loan amount as interest.
Where can I get 7% interest on my money? ›
7% Interest Savings Accounts: What You Need To Know
- As of June 2024, no banks are offering 7% interest rates on savings accounts.
- Two credit unions have high-interest checking accounts: Landmark Credit Union Premium Checking with 7.50% APY and OnPath Credit Union High Yield Checking with 7.00% APY.
Interest is the price paid for the use of credit or money. It may be expressed either in terms of money or as a rate of payment. The term interest also refers to the income that comes from contractual promises from others to pay sums in the future.
What is interest in simple words? ›
Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR). Interest may be earned by lenders for the use of their funds or paid by borrowers for the use of those funds.
What is the rule for simple interest? ›
A = P (1 + r*t) Where: A is the total amount (principal + interest), P is the principal amount, r represents the rate of interest, and t stands for time. Simple interest is a technique used to calculate the proportion of interest paid on a sum over a set time period at a set rate.
The formula for calculating simple interest is A = P x R x T.
- A is the amount of interest you'll wind up with.
- P is the principal or initial deposit.
- R is the annual interest rate (shown in decimal format).
- T is the number of years.
Interest affects the overall price you pay after your loan is completely paid off. For example, if you borrow $100 with a 5% interest rate, you will pay $105 dollars back to the lender you borrowed from. The lender will make $5 in profit. There are several types of interest you may encounter throughout your life.
How will you define interest in your own words? ›
: a feeling that accompanies or causes special attention to something or someone : concern. b. : something or someone that arouses such attention. c. : a quality in a thing or person arousing interest.
How do you calculate interest easily? ›
Interest = Principal x Rate x Time.
Where Principal is the initial amount invested. Rate is the interest rate charged and time is the duration of the investment.
How to find the simple interest rate? ›
The simple interest formula is given by I = PRt where I = interest, P = principal, R = rate, and t = time. Here, I = 10,000 * 0.09 * 5 = $4,500. The total repayment amount is the interest plus the principal, so $4,500 + $10,000 = $14,500 total repayment.
What is a simple interest quizlet? ›
Simple interest. Interest that is calculated one time on the principal. Simple interest formula. Interest = principal × rate × time.
What is the simple interest on 8000 for 15 months? ›
Calculate the simple interest on Rs. 8000 for 15 months at 6 paise per rupee per month. Here, the rate of interest and the time are given per month. Therefore, the simple interest is Rs. 7200.
