Overview Of Calculation Of Interest

Whenever money is borrowed the borrower has to pay a certain percentage of the amount borrowed to the lender. This is termed as interest. The amount which is borrowed or lent is known as the principal and the percentage charge on it is the interest. For the borrower the interest is the cost he or she pays for that money and for the lender it is the price at which he or she has agreed to lend.

For banks it is a key component as banks collect money from depositors and lend money to those in need of funds. They pay a lower percentage of interest to those who have deposited and charge a higher percentage interest to those whom they have lent the money to and this delta in interest rates becomes their profits.

Individuals with surplus would invest with banks in savings account and fixed deposits. Banks lend to individual by way of retail products such as home loans, car loans etc. Corporate also access bank funding and other forms of debt to fund purchase of assets like plant and machinery, land etc. for expansion purposes.

The rate of interest in any economy is a function of various macroeconomic parameters such as the money supply, fiscal policy, amount being borrowed, creditworthiness of the borrower and rate of inflation, the duration of the loan etc. There are the two types of interest are simple interest and compound interest.

Interest rates could be fixed or varying depending on predetermined terms and conditions of lending based on the above factors.

Simple Interest Calculation-

When the percentage interest is charged only on the principal account it is termed as simple or nominal interest. Other things being equal all interest payments in the first year of a loan would be simple interest. In the second year, interest which is earned in the first year is not added to the principal in case of simple interest. In other words the compounding effect is not there.

Let Us Take A Numerical Example-

Principal Amount = USD 50,000

Interest Rate = 6 percent

Simple Interest for Year 1 = 50,000 x 6 /100 = USD 3000

Even in Year 2, if the interest has to be calculated on simple interest basis, the interest will be USD 3,000 and 6 percent will not be charged on the aggregate figure of USD 53,000 which is principal plus first year's interest.

Compound Interest Calculations

In the case of compound interest, in the first year interest rate charged on the principal amount. However from the second year, interest is charged on the total of principal and the first year interest payment.

Let us take a numerical example:

Principal Amount = USD 50,000

Interest Rate = 6 percent

Interest for Year 1 = 50,000 x 6 /100 = USD 3000

For year 2

Compound Interest = (50,000 + 3000) x 6/100 = USD 3180

For Year 2

Compound Interest = (50,000 + 3000 + 3180) x 6/100 = USD 3370.8

The power of compounding is very effective when it comes to explaining investments. It is very important to understand how the interest calculation will be undertaken by the lender as it has significantly different financial implications on cash outflows for both individuals and corporate.

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