Review - Calculating Interest
Terminology:
Simple Interest-The method of calculating an interest expense based on the principal
balance, the annual interest rate, and the length of time that interest accrues. Most loans
are calculated on simple interest, even if the loan is an amortized loan.
Example: Borrow $ 1,000 for 6 months, at an annual percentage rate of 6.0%
1000 X .06 = interest charged for one year
1000 X .06 = 60 accrued in one year
But the term for this loan is on only 6 months. So we would determine the interest for 6
months by dividing it by the length of time we actually used it.
Six months is ½ of a year, so we could multiply the 60 for a year by ½ to get 30.
Also, we could have said that 6 months is 6/12 of a year, and evaluate that fraction to get
½. We can even say that 6 months is 182.5/365 days, evaluate that fraction by dividing
182.5 by 365 to get ½, and multiply the 60 by ½.
In practical terms for estimating interest for balance sheets and cash flow projections, it is
probably good enough to estimate the length of the loan in months, and calculate it from
there. If you want to as fine as the number of days, that is okay as well.
The important thing is to first calculate the interest for a year, then only charge the
amount of interest that would accrue for the length of time for the loan.
Compounding Interest-Compounding interest is typically found in savings accounts.
The period of compounding may be daily, weekly, monthly, quarterly, yearly or some
other period. In compounding interest the interest that accrues is calculated as it is in a
simple interest situation, but then the interest earned in that compounding period is added
to the principal before the accrued interest for the next period is calculated.
Example: a person has 1,000 in a savings account that earns 5.0% annually. Interest is
compounded monthly. For the first month the interest earned is $ 4.17, which adds to
the principal to get 1,004.17, which is then used to calculate the next month’s interest
earned: $4.18, which gets added to the principal balance for the month.