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Simple interest is interest paid only on the "principal"
or the amount originally borrowed, and not on the interest
owed on the loan.
For example, the simple interest due at the end of three years on a loan
of $100 at a 10% annual interest rate is $30 (10% of $100, or $10, for
each of the three years). No interest is calculated in the second year
on the $10 interest that was due after the first year, and no interest
is calculated in the third year on the interest that was due after two
years.
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Compound interest is interest calculated, not only on the principal,
or the amount originally borrowed, but also on the interest that has accrued,
or built up, at the time of the calculation.
Here’s how the amount owed on a three-year loan at an interest rate of
10% would differ, depending on whether simple interest or compound interest
was charged:
|
|
Simple Interest |
Compound Interest |
|
Amount of Loan |
$100 |
$100 |
|
Amount Owed After One Year |
110 |
110 |
|
Amount Owed After Two Years |
120 |
121
($110 plus 10% of $110) |
|
Amount Owed After Three Years |
130 |
133.10
($121 plus 10% of $121) |
Compound interest is what depositors receive on bank accounts, and it
makes their accounts grow faster than simple interest would.
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The "rule of 72" provides a way of calculating approximately
how many years it takes an amount of money to double when it receives
compound interest. The rule says you can find the answer by dividing the
rate of interest (expressed as a whole number ¾
for example, a 5% rate of interest equals 5) into 72. Thus, at 5% compound
interest, a sum will double in about 14 years (72 divided by 5), and at
10% compound interest it will double in about seven years (72 divided
by 10).
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Under the discount method, the interest that will be due
is calculated and withheld from the borrower when the
loan is made. For example, someone who borrows $1,000
for a year at a 10% interest rate would actually receive
just $900 ($1,000 minus 10% of $1,000, or $100), and then
pay back $1,000 a year later. The effective interest rate
would thus exceed 11% ($100 divided by the $900 that the
borrower had the use of during the year).
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