Interest is the fee paid for borrowing money. There are two common types of interest charged by lenders: simple interest and compound interest. To calculate interest of either type you need three pieces of information:

  • The principal – the original amount of money borrowed.
  • The interest rate – the percentage of the principle that must be paid per time period to compensate the lender.
  • Time duration – the length of time the money will be borrowed for, expressed as a number of time periods, generally years or months.

Simple Interest

Simple interest is interest that is charged only on the principal and is calculated by:

Principal x interest rate x time duration (number of time periods)

So, if you borrow $1000 at 5% simple interest per year for 5 years your calculation will be:
1000 x .05 x 5 = $250 interest

The total cost of your loan will be principal plus total interest – in this example $1250.

Compound Interest

Compound interest, by far the more prevalent form of interest charged in financial markets, is interest that is charged on the principal and on any accrued interest.

For example, if you borrowed $100 for two years at 5% compound interest per year, then at the end of the first year, assuming no repayments are made, you would be charged $5 interest (5% of $100). At the end of the second year you would be charged 5% interest on the principal again plus 5% on the interest you accrued during the first year i.e. on $105. Interest for the second year, therefore, would be 5% of $105 = $5.25.

Calculating the total amount that you’ll have to repay on a loan subject to compound interest is best done using the formula: P(1 + r)ⁿ where P = the principal, r = the interest rate, and ⁿ = the number of time periods the loan is for. So, for a loan of $1000 at 5% compound interest for 5 years your calculation would be:

= 1000(1.05) = 1000(1.28) = 1280

In this example the total cost of the loan is $1280.

To calculate total interest by itself, simply subtract the principal from the total cost of the loan: $1280 – $1000 = $280.

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