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Simple Interest:

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Learning objectives of this article:

  1. Define and explain the simple interest.
  2. How is it calculated?

Contents:

There are two ways to calculate interest. One is the simple interest and other is the compound interest. In this article simple interest is defined, explained and calculated. The concept of compound interest is explained on future value of a single sum page.

Definition and Explanation:

Interest is a fee which is paid for having the use of money. We pay interest on mortgages for having the use of the bank's money. We use the bank's money to pay a contractor or person from whom we are purchasing a home. Similarly, the bank pays us interest on money invested in savings accounts or certificates of deposit because it has temporary access to our money. The amount of money that is lent or invested is called the principle. Interest is usually paid in proportion to the principle and the period of time over which the money is used. The interest rate specifies the rate at which interest accumulates. The interest rate is typically stated as a percentage of the principle per period of time, for example, 18 percent per year or 1.5 percent per month.

Interest that is paid solely on the amount of the principle is called simple interest. Simple interest is usually associated with loans or investments which are short-term in nature.

Formula of Simple Interest:

The calculation of simple interest is based on the following formula:

Simple interest = Principle Interest rate per time period Number of time periods

Or

I = Pin

Where;

  • I = Simple interest, dollars
  • P = Principle, dollars
  • i = Interest rate per time period
  • n = Number of time periods of loan

In the above formula, it is essential that the time periods for i and n be consistent with each other. That is, if i is expressed as a percentage per year, n should be expressed in number of years. Similarly, if i is expressed as a percentage per month, n must be stated in number of months.

Examples:

Example 1:

A credit union has issued a 3-year loan of $5,000. Simple interest is charged at a rate of 10 percent per year. The principle plus interest is to be repaid at the end of the third year. Compute the interest for three year period. What amount will be repaid at the end of the third year?

Solution:

I = Pin

I = ($5,000)(0.10)(3)

= $1,500

The amount to be repaid is the principle plus the accumulated interest, that is:

$5,000 + $1,500

$6,500

Example 2:

A person lends $10,000 to a corporation by purchasing a bond from the corporation. Simple interest is computed quarterly at a rate of 3 percent per quarter, and a check for the interest is mailed each quarter to all bondholders. The bonds expire at the end of 5 years, and the final check includes the original principle plus interest earned during the last quarter. Compute the interest earned each quarter and the total interest which will be earned over 5-year life of the bonds.

Solution:

In this problem P = $10,000, i = 0.03 per quarter, and the period of the loan is 5 years. Since the time period for i is a quarter (of a year), we must consider 5 years as 20 quarters. And since we are interested in the amount of interest earned over one quarter, we must let n = 1. Therefore quarterly interest equals:

I = Pin

I = ($10,000)(0.03)(1)

= $300

To compute the total interest over the five year period, we multiply the per-quarter interest of $300 by the number of quarters, 20, to obtain

Total interest = $300 200

= $6000

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More study material from this topic:

Methods for the evaluation of capital investment analysis
Average rate of return or accounting rate of return method
Cash payback method
Net present value method
Internal rate of return method
Simple interest
Future value of a single sum
Future value of an annuity
Present value of a single sum
Present value of an annuity
Qualitative consideration in capital investment analysis
Capital investment analysis and unequal proposal lives
Capital rationing decision process
Difference between simple interest and compound interest
Difference between nominal and effective interest rate
Future value of $1 table
Present value of $1 table
Present value of ordinary annuity table
Future value of ordinary annuity table

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
----------------------------------------------------------------------------
  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 

 

 

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