Interest is the cost of borrowing money, and is a percentage of the
borrowed amount, usually expressed an an annual percentage rate (APR).
Interest applies both to consumers when they borrow money from banks in
the form of car and home loans, and to banks when they borrow money
from consumers in the form of savings accounts.
There are two main types of interest: simple and compound. For simple
interest, the amount every year is based on the borrowed amount, which
is called the principal. Car and home loans use simple interest. For
compound interest, the amount every year is based on both the principal
and accumulated interest. Savings accounts use compound interest, which
will be discussed in a later section.
To calculate simple interest from a principal, APR, and number of
years, divide the APR by 100 to get a decimal, multiply that by the
principal to get the yearly amount, and multiply that by the number of
years to get the total amount.
For example, you borrow $100 with 10% interest, and pay it back in 3
years. To calculate the interest amount, do the following:
principal = $100
percent = 10
decimal = 10 ÷ 100 = 0.1
yearly = $100 × 0.1 = $10
years = 3
total = $10 × 3 = $30
Interest is usually paid in monthly payments. If just the interest
amount, and not a portion of the principal is paid every month, it is
called an interest-only loan. To calculate the monthly payment, divide
the yearly amount by 12.
In reality, for car and home loans, both a portion of the principal and
the interest amount are paid every month. This means the loan is slowly
paid back each month, which also reduces the interest each month. This
is called an amortizing loan, but that's beyond the scope of this
section. For the exercises below, treat all loans as interest-only