Tax Guide |
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The two most common methods of calculating interest use the simple interest and the compound interest formulas.
Simple interest. Simple interest is the dollar cost of borrowing money. This cost is based on three elements: the amount borrowed, which is called the principal; the rate of interest; and the time for which the principal is borrowed. The formula used to find simple interest is:
interest = principal x rate of interest x amount of time the loan is outstanding
or
I = P x R x T
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Compound interest. Unlike simple interest, compound interest calculates interest not only on the principal, but also on the prior period's interest. The formula for calculating compound interest is:
Future repayment value = principal x (1 + rate of interest)amount of time
or
F = P x (1 + R)T
The factor (1+ R)T can be obtained easily using pencil and paper, a calculator, or a compound interest table. Most consumer loans use monthly or, possibly, daily compounding. Thus, if you are dealing with monthly compounding, the "R" term in the above formula relates to the monthly interest rate, and "T" equals the number of months in the loan term. Likewise, if the loan in question uses daily compounding, the "R" term relates to the daily interest rate, and "T" equals the number of days in the loan term.
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