As a percent (per year) of the amount borrowed
Example: Borrow $1,000 from the Bank
Alex wants to borrow $1,000. The local bank says "10% Interest ". So to borrow the $1,000 for 1 year will cost:
$1,000 × 10% = $100
More Than One Year.
Example: Jan borrowed $3,000 for 4 Years at 5% interest rate, how much interest is that?
But the bank says "If you paid me everything back after one year, and then I loaned it to you again. I would be loaning you $1,100 for the second year !"
And Alex would pay $110 interest in the second year, not just $100.
Because Alex is paying 10% on $1,100 not
This may seem unfair. but imagine YOU were lending the money to Alex. After a year you think "Alex owes me $1,100 now, and is still using my money, I should get more interest!"
And so this is the normal way of calculating interest. It is called compounding .
With compounding we work out the interest for the first period, add it the total, and then calculate the interest for the next period, and so on. like this:
It is like paying interest on interest: after a year Alex owed $100 interest, the Bank thinks of that as another loan and charges interest on it, too.
After a few years it can get really large. This is what happens on a 5 Year Loan: