Interest Calculator: Understanding How Interest Works?

Answer 1

At some point in time, you will have to deal with interest. If you have a savings account or a certificate of deposit account, you will be gaining interest. If you have a loan or credit card, you will be paying it. Either way, it is important to understand how interest is figured out. There are two types of interest you should understand. Below is a guide to figuring out simple interest and compound interest.

Simple Interest

Simple interest is the amount of interest you gain or pay based on a principal balance. The simple interest rate you are given is based on a principal balance. To figure out simple interest, you multiply the principal balance by the interest rate. You then multiply that by the duration. If you want to figure out how much interest you gain after one year, you would use one for the duration. If you want to figure out how much interest you would get after three months, you would use one quarter for the duration.

For example, if you have $100 deposited in to a savings account with a 2% interest rate and want to know how much interest you will gain after 6 months, you would set multiply 100 by .02 by .5. That will tell you that you earned $1 of interest after 6 months.

Compound Interest

Compound interest is similar to simple interest. The difference is that interest is eventually added to the principal. This changes the principal balance after a certain amount of time. The time can vary, but it usually compounds annually.

The equation works similarly, except your principal will change. Using the same example above, let's say you want to figure out how much the interest will be after two years. For the first year, your principal would be $100. You would then multiply that by 2%. This means you gain $2 of interest after one year. This then becomes part of the principal. For the second year, you are multiplying $102 by 2%. This means over the course of two years, this means your total interest is $4.04.

When calculating interest for credit cards, most companies usually use your average daily balance. Essentially, you would add up your daily balances over the course of a month and then divide that by the number of days in the month. Then, divide your annual interest rate by 365 to get the daily interest rate. Multiply your average daily balance by the daily interest rate. Then, multiply this number by the number of days in the month. That will tell you how much interest you must pay that month.