Define Interest In Simple Terms
Interest is an amount of money charged to a borrower as the cost of taking out a loan or issuing debt.
This is expressed as a percentage of the principal of the amount borrowed.
This amount must be paid in addition to repayment of the full principal.
What Is Simple Interest In Finance?
Simple interest is calculated as a percentage of the principal that is periodically added to the total amount due.
For example, a $1,000 bond with a 5% coupon rate charged annually would add $50 to the amount due each year.
If the bond lasts for 20 years, the amount owed would be $1,000 + ($50 * 20), or $2,000 (assuming the bondholder kept the bond until maturity).
If an investor were to hold just ten of these to maturity, then they would have made a $10,000 profit over 20 years.
Compound Interest Example
Interest paid on loans is usually more complex than simple interest allows.
For example, most loans use compounding interest instead of simple interest.
When interest compounds, it means that every time an amount is added to the principal, the interest rate takes a percentage of the new amount instead of the original principal.
Let’s say that an investor took out a $10,000 loan instead of buying $10,000 of bonds.
If the above example used compounding interest, then after the first period, the loan balance would still be $10,500; however, the next time interest was charged, it would be out of $10,500 rather than the original $10,000.
To calculate compound interest, use the equation:
“n” is the number of compounding periods.
Using the above example gets $10,000*[(1+0.05)20-1], or $10,000 * (1.65), or $16,532.98.
This is added to the principal for a final amount due of $26,532.98, which is more than $6,500 more than in a non-compounding environment.