Interest Rates Part 3 - Simple Interest

Not only do we need to know the interest rate, we need to know what time period the rate applies to, but we also need to what method to use:   What?!?  This is where the math starts getting hard.

Simple interest:  This method is the starting point for understanding how complicated it can get.

Simple interest is interest that is only charged on the original principal - this is the most basic way to calculate interest and it's not how most lenders do it.  But we must start here to understand how it's really done.

If I borrow $100.00 for    1 year at 10% annual interest and the method used is simple interest – then the cost to borrow for 1 year is calculated like this:

$100 X .10 = $10

The cost to borrow for 2 years is $100 X .10 X 2 = $20 (amount borrowed  x rate x time).   The cost to borrow for 10 years is $100.00 X .10 X 10 = $100. 

If I wait 10 years to  pay the  loan back, I pay back $200.  ($100 is the original loan and $100.00 10 years’ worth of simple interest at an annual rate of 10%).

$100 X .10 = $10 year 1 interest

$100 X .10 = $10 year 2 interest

$100 X .10 = $10 year 3 interest and so on.

Interest rate part 2

We need to know more about the interest rate to understand what the cost of money really means.

One thing we need to know is what time period it covers – is the rate annual?  Am I paying 10% per year?  Per month? Per day?

If the rate is 10% per year, then $100 borrowed on January 1, year 1 and paid back on January 1 year two is calculated like this:  $100 times 10% (or .10) = $110.00.  

It costs $10.00 to borrow $100.00 for 1 year.

If the rate is monthly, then to borrow the same $100.00 paid back in 1 year could look like this:

Then we calculate the interest like this: $100 X .10 X 12 months = $120.00 plus the original loan amount (the principal) of $100.00 and we see we have to pay back $220.00.  WOW.  10% per month is WAY different than 10% per year.   It’s WAY more expensive.   Most of the time the interest rate stated is an annual rate.