Paying interest on borrowed money is common; in fact, no commercial lender will loan money to you without charging interest. Interest is essentially the premium you pay for the privilege of borrowing money, and it is always a percentage of the amount still owing. Typically, the lender will charge an annual interest rate, but you can convert a monthly interest rate to annual by doing some simple math.
What Is an Interest Rate?
Interest is what a lender charges a borrower for loaning money. You agree to repay a loan with interest in exchange for receiving the money. The interest rate is the percentage used to calculate the amount of interest due on the loan; if you take out a loan with an 8 percent interest rate, you'll pay 8 percent interest on the loan.
Most lenders use an annual percentage rate (APR) when assessing interest. The APR is actually interest plus other costs to the lender converted into a percentage, but it is widely accepted to simply mean interest.
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How the interest is calculated depends upon whether you agree to pay simple interest or compound interest.
What Is Simple Interest?
Simple interest is interest calculated on the amount you borrowed. If you borrow $10,000 and agree to pay it back within one year at 8 percent simple interest, you'll end up paying back $10,800 total: the $10,000 you borrowed (the principal) and $800 in interest (8 percent of $10,000).
What Is Compound Interest?
Compound interest is paying interest not only on the principal balance but also on accrued interest. If you borrow $10,000 and agree to pay it back in two years at 8 percent interest, and the interest is compounded annually, you'll pay back $11,664: the $10,000 you borrowed; the $800 in interest from the first year (8 percent of $10,000); and $864 in interest from the second year (8 percent of $10,800, which is the principal plus interest from year one).
Compound interest can become tricky if compounded monthly, daily or weekly instead of annually; additionally, if you make payments throughout the year, the amount you pay will be affected.
Interest Rate Formula
The formula for calculating simple interest is P x R x T (principal x interest rate x time). If you agree to pay back $10,000 over five years at 8 percent interest, you'll pay $4,000 in interest: $10,000 (principal) x 0.08 (8 percent) x 5, which is $4,000. The total you'll pay is $14,000.
Compound interest requires more work. The easiest way to calculate it is to make a chart; start with simple interest in year one, and for each year thereafter, add the interest and begin a new calculation.
For example, if you borrow $10,000 and agree to pay it back over five years at 8 percent interest compounded annually:
- You'll owe $10,800 for the first year, as set forth above.
- In the second year, you'll accrue 8 percent interest on $10,800 (the principal plus the interest from year one), which is $864, and thus at the end of the second year, you'll owe $11,664.
- In year three, you'll accrue 8 percent interest on $11,664, which is $933.12, for a total of $12,597.12 owed by the end of year three.
- In year four, you'll accrue 8 percent interest on $12,597.12, which is $1,007.77, for a total of $13,604.89 owed at the end of year four.
- In year five, you'll accrue 8 percent interest on $13,604.89, which is $1,088.39, for a total of $14,693.28 paid for the loan.
If you make regular payments on the loan, the interest you pay will depend on how your lender applies the money you send.
Monthly Interest Calculations
If your lender charges you interest monthly instead of annually, the formulas are the same; you simply take the rate of interest (8 percent) and divide it by 12 to figure out how much interest is charged monthly. Eight percent divided by 12 equals 0.00667, or 0.67 percent. If you have a loan balance of $1,000, your interest for one month would be $6.70 ($1,000 x 0.0067).
Convert a Monthly Interest Rate to Annual
To calculate monthly interest from APR or annual interest, simply multiply the interest for the month by 12. If you paid $6.70 in interest per month, your annual interest is $80.40.