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# Interest Calculator What is an interest calculator?

An interest calculator is a way for individuals, and businesses, to determine the expected cost, or income of giving and accepting loans.  An interest calculator can also be used by investors to determine the amount of money they can expect from returns on investments.  There are many different types of interest calculators that range from the very basic to the complex.

Definitions

Before going into any conversation about interest calculators it is important to know the different ways that interest can be computed and how it will effect your decision making.  The three main types of interest calculators that are used in most financial transactions are simple interest; compound interest; and amortized interest.

Simple interest, as per its definition, is a very simple interest calculator.  A simple interest calculator formula will be: Interest=principal (x) interest rate (x) length of time.  For example, if you receive a loan for \$1,000 for one year at an interest rate of 7% the tax calculation will be as follows:  1000 (x) .07 (x) 1.  This will give you an annual  interest payment of \$70.  This is the most basic type of tax calculator, but this is usually not the case in most financial transactions.  Most financial transactions involve some form of compounding.

Compound interest is a more complex form of interest calculator.  In a compound interest calculator the amount of money interest is charged to increases over time.  This is reflected in the Annual Percentage Yield.  An example of a compound interest rate would be a savings account.  You may have a savings account that has a 4% interest rate.  When this is compounded the total interest you receive will be slightly more than 4% depending on how often that interest is compounded.  When looking for investments or picking a bank to have a savings account the amount of interest that the bank offers is only one of the factors that you should use in your interest calculator.  You should find out how often that interest is compounded.  Most banking institutions compound interest on a monthly basis.  This means that your interest on your investment will be calculated every month and every month that new figure will be subject to the interest rate for the next month.  For example, if you invest \$1000 in a savings account that has a 5% interest rate that is compounded monthly then the interest calculation will look like this:

Initial investment:  \$1000

End of month 1 at 5% interest: \$1050

End of month 2 at 5% interest:  \$1,102

End of month 6 at 5% interest:  \$1,276

End of month 12 at 5% interest: \$1,795

In the previous example the interest calculator works by multiplying the newly generated balance every month by the interest rate, 5%.  As you can see by having compounded interest the interest calculator generates an end of year balance of exceedingly more than if we followed the simple interest calculator, which would leave you with a year end total of \$1,050.  If you have investments for extended periods of time it is often simpler to use a tax calculator that involves converting the interest rate to the power of whatever amount of time the interest will be compounded for.  For example, if you have a \$1,000 investment that accumulates interest on a monthly basis at 5% interest compounded over the course of 5 years you will want to use the following calculation:

Interest=(principal (x) (1+interest rate)^(months(x)years of investment))- principal

Interest = (1000 (x) 1.05^(12(x)5)) – principal

Interest = (1000 (x) 1.05^60) – 1000

Interest =(1000 (x) 18.58) – 1000

Interest = 18,580 – 1000

Interest = 17,580

Credit card companies often use the same interest calculator but the amount of money that you owe on your credit card is often compounded daily.  This is one of the reasons why it is beneficial to maintain a month to month balance where you pay off the amount you owe as soon as you receive your bill.   Those individuals who maintain a high credit card balance will find that they are paying large sums of money in interest, which is akin to throwing money in the toilet.  Student loans also use compounded interest rates.  It is important, when getting student loans, to find out when they begin compounding.  Subsidized student loans do not begin compounding interest until after you have completed your education, or left.  Unsubsidized loans begin to compound interest as soon as they are taken out.  It is these loans that can cause individuals to owe exhorbitant amounts of money upon graduation.  It is important to use a interest calculator to decide how much the loan now will cost you in the future.  Find out whether, and how often, the interest on all loans are compounded by using the interest calculator. .  It may be more beneficial for you to take a loan at 4% interest compounded yearly than to take a 1% loan that is compounded on a monthly basis.

There are also things called amortized interest .  To calculate amortized interest one uses interest calculators in a different way.  Amortized interest calculators are used when you receive a mortgage, car loan, or any other type of loan from a lending institution.  An amortized interest rate is negotiated along with a period of time for repayment.  This is usually done with large investments where payment needs to be spread out over a long period of time.  For example, when you get a mortgage for real estate you will often get a mortgage with a specific interest rate that is amortized, or depreciated, over a period, usually between 20 and 30 years.  As in the above discussion, this interest rate is compounded over the period of time of the loan.  In an amoritized interest calculator  each payment that you make will pay for the interest accumulated over that period of time and also allocate a specific amount towards the principal of the loan.  In describing how amortization works it is easier to leave out the computation for compounding.  If your mortgage is compounded over a period of months or years you should use an interest calculator that reflects that but for this example we will make it simple.  In this example you have a mortgage of \$300,000 at 5% interest that is amortized over a period of 30 years that is paid on a yearly basis.  The interest that you pay is \$15000 or the first year.  In addition to the interest you will also pay 1/30 of the principal.

1st year payment = interest + 1/30 of principal

1st year payment = \$15000 + \$10,000

1st year payment = \$25,000

By using this interest calculator you determine that your first year payment is \$11,500, which includes interest and 1/30 of the principal balance.  The total principal is amortized, in that the total principal is diminished in that one year period.  As a result, your next years payment is decreased.  This happens over the course of the 30 year life of the loan until the loan is completely paid off.  Now let’s calculate the second years payment.  First you need to use the interest calculator to determine what your updated principal balance is:

2nd year principal balance = \$300,000 – first years payment on principal

2nd year principal balance = \$290,000

Once this is done you use the previous calculation to determine the payment for the 2nd year:

2nd year payment = (5% interest on outstanding principal) + (1/30  of initial mortgage)

2nd year payment = (5% of \$290,000) + (10,000)

2nd year payment =\$14,500 + \$10,000

2nd year payment = \$24,500

As you can see, by using the interest calculator, the total amount that is due at the end of each successive year diminishes.  This is due to the decrease in the amount of principal that interest is charged to.  This calculation becomes more complex when the interest is compounded on a monthly basis.

Fixed and Variable Interest calculator

In addition to the basic principle of simple interest, compound interest and amortized interest there are other factors that need to be included in the interest calculator that can severely affect the amount of interest, and the long term nature of your loan, or investment.  These are the interest rates that are charged by lenders.  There are two main types of interest rates that are charged by lenders, and should be used in your interest calculator.  These are fixed interest rates and variable interest rates.

A fixed interest rate is, just like it sounds, fixed over a period of time.  If you get a loan at a fixed interest rate of 5% for the life of the loan that means that, no matter what the economic conditions, you will be charged an interest rate of 5% over the life of the loan.  For example, if you have a yearly fixed interest rate of 5% for a 10 year loan you will pay 5% interest on your outstanding balance in year one and 5% interest on your loan in year 10.

When you have a variable interest rate it gets a little more complicated and a little more risky.  In a variable interest calculator a lender will provide you with a fixed rate of a certain amount of interest on top of a variable interest that is determined by the federal reserve.  For example, your lending institution may charge you a 2% interest rate in addition to 3% interest that is designated by the federal reserve for a total of 5% interest for the life of the loan.  The interest rate charged by the federal reserve changes over time and may decrease or increase.  In the previous example, if you have a variable interest loan and the federal reserve increases its interest rate to 5% your interest will be reflected by the increase and, using the interest calculator, you will realize a new interest rate of 7%.  The interest calculator is more complex than this for the increase in the interest rate by the federal reserve will be retroactive to the beginning of your loan.  In other words, if you have a 10 year loan with a 2% interest rate from the lender and a 3% interest rate at the federal reserve level then your interest rate is 5%.   This may continue for 2 years and then the federal reserve raises interest rates for the following 8 years to 5%.  This will not only increase your interest rate to 7% but the lender will charge you more interest to make up for the diminished interest rate you paid in the first 2 years.  Essentially, for the last 8 years of your loan you will be paying an interest rate so that the life of your loan reflects an annual 7% interest rate.

Variable interest rates can have their advantages and disadvantages.  For one, the interest rate by the federal reserve may diminish, which means that the interest rate that you initially agreed to will be decreased for the life of your loan.  Those investors who have a great knowledge of the securities market can predict increases and decreases in the federal reserves interest rates and take advantage of predicting the federal reserves decisions in their interest calculators.  Variable interest calculators are also beneficial for individuals who are investing in short term projects.  Those who invest when interest rates are low are more likely profit if they invest for a short period of time before federal reserve interest rates change.  Those who are investing long term assets should stick to fixed interest rates.  Variable interest calculators are also beneficial in that there is more risk involved in a variable interest rate loan.  In that regard, lending institutions are more likely to offer variable interest rate loans at a lower interest rate than if they were to offer fixed interest rates.  The downside to using variable interest rates is that is less favorable to planning.  Because you are unaware of how much interest you will be charged in the overall investment you will need to keep money on hand in the case that interest levels increase and you are required to make larger payments than you initially intended.