Buzz
Most people are familiar with the concept of interest, but not everyone knows how to calculate it. Interest is the value added to a loan or deposit as compensation for using someone else's money over time. There are three basic methods to calculate interest. Simple interest is the easiest method, often applied to short-term loans. Compound interest is slightly more complicated and yields a bit more. Lastly, continuous compound interest is the fastest growing interest and is the formula used by most banks for mortgage loans. The required data for all these methods is generally the same, but the calculations differ slightly.
Steps
Calculating Simple Interest
Determine the principal amount. The principal is the amount of money you will use to calculate the interest. This could be the amount you deposit into a savings account or some form of bond. In this case, you will earn the interest calculated. On the other hand, if you borrow money, such as a mortgage, the principal will be the amount you borrowed, and the interest calculated is the amount you need to pay.
- In both cases, whether you earn or pay interest, the principal amount is typically represented by the variable P.
- For example, if you lend a friend $2,000, your principal would be $2,000.
Determine the interest rate. Before calculating how much your principal will grow, you need to know its rate of increase, which is the interest rate you will apply. Interest rates are typically published or agreed upon by both parties before the loan is made.
- For example, let's say you lend a friend money with an agreement that they will repay you $2,000 plus an interest rate of 1.5% after 6 months. Before applying the 1.5% interest rate, you must convert it into a decimal. To convert a percentage into a decimal, divide the percentage by 100:
- 1.5% ÷ 100 = 0.015.
Determine the loan term. The loan term refers to the length of time for the loan. In some cases, the loan term is agreed upon when the money is borrowed. For example, most mortgages have a set term. With many personal loans, the borrower and lender may agree on any loan term.
- What's important is that the loan term matches the interest rate, or at least shares the same unit of time. For instance, if the interest rate is calculated annually, the loan term should also be in years. If the interest rate is 3% per year but the loan term is only 6 months, you would calculate the interest rate annually and set the term at 0.5 years.
- Another example, if the interest rate is agreed to be 1% per month and the loan is for 6 months, the loan term would be calculated as 6 months.
Calculating the interest.
Consider another example.Compound Interest Calculation
Understanding the concept of compound interest.
Knowing the initial principal amount.
Calculate the interest rate.- For example, a credit card has an interest rate of 15% per year. However, the interest is typically paid monthly, so you may want to know what the monthly interest rate is. In this case, we divide the annual interest rate by 12 to find that the monthly interest rate is 1.25%. Therefore, an annual rate of 15% is equivalent to a monthly rate of 1.25%.
Understand when the interest is compounded. Compound interest means that the interest will be calculated based on the period and added to the principal. For some loans, interest is compounded annually. Other loans may be compounded monthly or quarterly. You need to know how many times the interest is compounded each year.
- If interest is compounded annually, then n=1.
- If interest is compounded quarterly, then n=4.
Know the loan term.
Identify the variables of the given scenario.
Apply the formula to calculate compound interest.Continuous Compound Interest Calculation
Understand the concept of continuous compound interest.
Know the variables used to calculate interest.
Know the details of the loan.
Apply the formula to calculate the interest.
