Simple interest

Simple interest: Simple Interest is the product of the principal, the interest rate (per period), and the number of time periods. To find the simple interest: c=prt, where c (simple interest) is found as the product of p (principle), r (rate), and t (time). For example: Jim borrows $23000 to buy a new car, and the rate is 5.5% over five years. What is the resulting simple interest?
$23000 * 5.5% * 5 = $6325

The simple interest on Jim's auto loan is $6325. If Jim repays his debt in full, he will repay the principal plus the interest, or $29325. To calculate the simple interest rate r, add together all interest paid, or payable, in a period. Divide the result by the principal at the beginning of the period. The result is the simple interest rate. For example, given a $100 principal:

Credit card debt where $1/day is charged: 1/100 = 1%/day. Corporate bond where the first $3 are due after six months, and the second $3 are due at the year's end: (3+3)/100 = 6%/year. Certificate of deposit (GIC) where $6 is paid at the year's end: 6/100 = 6%/year.

There are three problems with simple interest.

The time periods used for measurement can be different, making comparisons wrong. One cannot claim that 1%/day of credit card interest is 'equal' to a 365%/year GIC. The time value of money means that $3 paid every six months costs more than $6 paid only at year end. So the 6% bond cannot be 'equated' to the 6% GIC. When interest is due, but not paid, the consequences are unclear. For example, does it remain 'interest payable', like the bond's $3 payment after six months? Alternatively, will it be added to the original principal, as would typically be the case in the 1%/day borrowed via the credit card? In the latter case, it is no longer simple interest, but compound interest.

[edit] Compound interest

Compound interest: Compound Interest is very similar to Simple Interest. The difference is that the principal changes with every time period, unlike simple interest, where the principal remains the same. The new principal at the end of every time period is essentially the simple interest on the principal at the beginning of the time period, added to the principal. For example, suppose p is the principal, and r and t have the same meanings as above. The principal at the end of the first period will be p*r (for t=1 period). Similarly, the

principal at the end of the second period will be (r*r)*r. Thus we can land upon a general formula:
CI = p * (r)t CA = r * ( 1 + r )t

Where compound interest (CI) is the product of the principal (p), and the rate (r) in decimal form raised to the power of the number of terms (t); and the compound amount (CA) is the product of rate (r) and the quantity of the rate (r) plus one, raised to the power of the number of terms (t). A problem with compound interest is that the resulting obligation can be difficult to interpret. To simplify this problem, a common economics convention is to disclose the interest rate as though the term were one year, with annual compounding, yielding the effective interest rate. However, interest rates in lending are often quoted as nominal interest rates, i.e., compounding interest uncorrected for the frequency of compounding. The discussion at compound interest shows how to convert to and from the different measures of interest. Loans often include various non-interest charges and fees. One example are points on a mortgage loan in the United States. When such fees are present, lenders are regularly required to provide information on the 'true' cost of finance, often expressed as an annual percentage rate (APR). The APR attempts to expresses the total cost of a loan as an interest rate after including the additional fees and expenses, although details may vary by jurisdiction. In economics, continuous compounding is often used due to its particular mathematical properties.