The science behind interest

 In Finance

Interest makes up a percentage of a loan (or deposit) balance which needs to be paid to the lender during a set amount of time. When borrowing money you not only have to repay what you’ve borrowed but also an additional sum in order to compensate the lender for the risk they are taking in lending you money.

If you however have extra money available, you can deposit it into a savings account and allow the bank to lend it out. You will then earn interest on that money.

How much is the interest?

Well, that depends solely on the interest rate which is ever changing. The interest is usually quoted as a percentage rate per year. The higher the rate the more the borrower has to pay.

Earning interest

This is the position you preferably should be in. When you deposit funds into an interest-bearing bank account the bank will use your money to offer loans to other customers and make other investments. Every month or quarter the bank will pay you interest on your savings.

You can choose to spend it or leave it to really accumulate. If you choose the latter then you will have the benefit of earning interest on that money as well as on your original deposit.

Paying interest

Each month a portion of the money you owe goes to the borrower as well as a sum of interest. With some loans you pay an amount of money over a specific period such as a mortgage while other loans are revolving like credit cards meaning you can borrow more money month after month.

If you neglect to make your repayments then the interest and payments you own starts backlogging and increasing, a situation you do not want to be in.

Simple Interest

Simpler interest is a quick way of calculating the interest charge on a loan and usually applies to car or short-tern loans. This is determined by multiplying the daily interest rate by the principal by the number of day that elapse between payments.

Simple interest = P x I x N

Who stands to benefit from simple interest loans?

Since it is calculated on a daily basis it is mostly beneficial to consumers who pay their loans on time or in advance. If you make your payments early every month, your main balance will shrink faster and you will thus pay off sooner than the original time.

Types of loans using Simple interest

This type of interest usually applies to car or short-term personal loans. Mortgages do not use simple interest although some banks use the same method for mortgages that have a bi-weekly payment plan.

 

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