How to Compute Interest

Personal debt is a fact of modern American life. Basic savings tools including bonds, savings accounts and money market accounts are the bedrock of any personal financial plan. Using either of these types of accounts properly requires a sound understanding of how both simple and compound interest work.

Instructions

1

Recognize that there are two standard forms of interest: simple and compound. The basic form of interest is simple interest. This is computed only on the principal.

2

Compute simple interest as an annual rate multiplied against the amount owed. For example, if you borrowed $25,000.00 at a simple annual rate of 8 percent, the annual interest would be computed as 25,000 times .08, for a sum of $2000.00.

3

Recognize that even computing simple interest is rarely so simple. Although interest rates are announced based on an annual rate, your payments are almost never made once per year. Once per month is more common, especially for credit cards. To arrive at this computation, add the extra step of dividing the interest rate by the number of payment periods. For example, if you owed $2000.00 on a credit card with 20 percent interest, to figure your monthly interest you would divide .20 (the annual rate) by 12, for a monthly rate of .016. Multiply 2000 by .016 for a monthly interest of $32.

4

Computing compound interest is similar, but adds the extra step of adding unpaid interest to the principal. For most of us, compound interest becomes an issue in interest-yielding bank accounts. If you have a CD which compounds its interest quarterly, that means your interest is added to the principal investment after three months.Most loans and credit cards in America actually operate on the basis of compound, rather than simple interest. The Annual Percentage Rate displayed on your bills is not the same thing as a true, simple annual interest rate. Rather, it is an estimate on the part of your bank or credit card company of what your compound interest rate looks like on an annual basis.

5

Determine whether you have a fixed or variable interest rate. A fixed rate is exactly that--all legal circumstances having been met, the rate never changes throughout the duration of the account. A variable rate will change, and it is important to understand the circumstances that will cause and set those adjustments.