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Interest

When you take out a loan from a bank, you're expected to pay back every penny of that loan amount as well as a fee on top of it, and that additional fee is what interest is.

There are two types of interest rates, and how high or low it is depends on your credit score. Interest is often calculated as a yearly rate, known as Annual Percentage Rate or APR. There are two types of interest rates: simple interest rate and compound interest rate.

Simple interest is calculated by multiplying the loan amount by the interest rate percentage (in most you need to move the interest rate decimal over two places, so 10% becomes .10) and then multiplying that by the number of years the loan is expected to be paid back in.

  • Simple interest = Loan amount x Interest rate percent x Time

For example, you take out a loan of $10,000 to start up a landscaping business, and the bank's terms for the loan are 7% interest rate with the loan expected to be paid back within 7 years. The calculation for simple interest would be:

  • $10,000 loan
  • 7% interest rate
  • 7 years to pay back
  • $10,000 x 0.07 x 7
  • Your simple interest would be $4,900

Again, the interest rate is in addition to the loan amount, so in the end you would be paying back a total of $14,900.

Compound interest is more complicated to calculate than simple interest, but the basic idea is that you're also paying interest on the interest you've previously paid. The number of times it actually "compounds" and you have to pay on the new amount (loan amount + interest paid) can vary, but it could be monthly, quarterly, or yearly.

Using our previous example of the $10,000 loan with 7% interest rate and 7 years to pay back, the compound interest (compounding once a year) would end up being $6057 compared to the simple interest of $4,900.

Interest not only applies to loans, but also credit cards (usually at a much higher rate), so you should be careful when spending large amounts of money with one.