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- There are two types of interest that most people need to worry about--interest that you pay to someone else and interest that someone else pays to you. There are several different ways of calculating both types. Which method you are subject to will depend on your agreement with the other party. For example, credit card interest is calculated using a different set of rules than mortgage interest, as per the terms of your agreement.
- Simple interest is the most basic type of interest and the easiest to calculate and understand. The formula for simple interest is I=p*r*t, or interest=principal*rate*time period. For instance, if you have $100 and you invest it at 7% per year for one year, the interest will be $7, or 100(p)*.07(r)*1(t). Most other types of interest rates are based on this simple equation, but they are a bit more complex.
- Savings account interest is probably the most common type of interest that individuals earn. Most savings accounts calculate interest monthly, using a method called annual percentage yield, or APY. APY is the amount of interest you earn over a year, but it's a little different than simple interest in that it takes compounding into account. For instance, if your bank offers a 4% per year interest rate on your savings account but compounds your interest monthly, you will actually earn slightly more than 4% on your money over the course of the year. Basically, the bank takes that 4% and divides it by 12 (the number of months in a year), which equals .3333%. They then pay you .3333% interest on your money each month instead of 4% all at the end of the year. Therefore, if you had $100, at the end of the first month, you would earn $.33 (.3333% *100). The following month, you will earn .3333% on the full $100.33 that you now have in your account. Each month you would earn interest on that slightly higher balance, resulting in more than 4% interest over the course of the year. The more frequently the interest compounds, the more interest you earn.
- This compound interest formula is also used by creditors to determine how much interest you will pay on money that you owe to others. Credit cards are well known for compounding interest daily, because as in the example above, the more frequently they compound the interest, the more money they earn. Credit card interest can also be calculated using an average daily balance, which can further increase your interest rate. For instance, if you have a $1,000 balance on your card on the first day of your 30-day billing cycle and you pay it off on the second day, your average daily balance for that billing cycle would be $33, or $1,000/30. If you wait until the 29th day of the billing cycle to pay it off, your average daily balance would be $966, or $29,000/30. Obviously, the earlier you pay your bill, the less interest you will be charged. Luckily, this usually only applies if you carry a balance from month to month--those who pay their credit cards in full each month are not normally charged interest.
- Amortized interest (like what you pay on mortgage or car loans) is another type of interest that many people will encounter. In this case, the payments on the loan are calculated so that you pay all of the interest due each month plus a small amount of the principal. Each time you pay, the principal amount becomes slightly smaller, so each successive payment makes a slightly larger dent in the principal because the interest is being calculated on a smaller amount. For example, if you borrowed $1,000 at 6%, after one month you would owe the bank $1005 (6%/12 months = .5%, .5%*1000=$5). If you paid the bank $6, you would only owe them $999, so the following month your interest would only be $4.99. The payment on an amortized loan is calculated so that the loan is paid off in just the right size increments to equal the desired number of payments. Five years with 60 payments is common for car loans, while 30 years with 360 payments is common for mortgages.
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