How to calculate interest on loan

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.

Compound Interest

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

just \$1,000

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:

Source: www.mathsisfun.com

Category: Credit