What is Interest?
Interest is the cost of using someone else’s money! So if you
- borrow money from a bank or a person, you have to pay it back to them “with interest”.
- lend money to a person or deposit money in a bank, the lender or bank have to pay back the money + interest to you.
So, interest is extra money that must be paid along with the original loan money.
How is interest paid?
Interest is paid as a percentage of your loan or deposit, paid to the lender on a regular schedule (monthly or yearly) for use of their money.
There are three important factors in borrowing or lending:
- The amount of the loan, also called principal or capital. Notation = P.
- The rate of interest (usually % of the principal). Notation = R.
- Time for which loan is given, also called loan term. Notation = T
- Borrow money: I borrow $200,000 from ABCD Bank to buy the new Tesla Roadster at an interest rate of 10% per year over 5 years. So, I’ll have to pay back not only the $200,000 in 5 years but interest money of 10% of that $200,000 every year to ABCD Bank.
- Earn interest money: I have $2000 in a savings account at XYZ Bank. The bank pays me 2.1% interest every month on this money. So, my $2000 keeps growing every month with an extra 2.1% interest on it. It lends this money out to other customers or invests this money in mutual funds or other investments.
What is Simple Interest?
Simple interest is an easy process for calculating the amount of money that is owed by the interest. The word “simple” means you’re using the simplest way of calculating interest.
Simple Interest Formula:
I = P x r x t
Let’s translate: Simple interest (I) = product of Principal (P) x Rate (R) X Time (T).
Where is simple interest used?
In very few places, actually. You may use simple interest if you borrow or loan money to friends or family, but not in business situations, or anywhere a bank or other financial institution is involved.
Next up: Compound Interest – the what, why, where, and how of it!