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.

### Tip

Using the interest rate formula for interest over one year, you can calculate monthly interest by dividing that amount by 12.

## 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.

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.