The interest rates lenders charge on debt will depend upon various factors and influences. Some of these elements include the following:

  • State of the economy
  • Supply and demand for debt
  • Rates set by central banks (Federal Reserve in the U.S.)
  • London Interbank Offered Rate (LIBOR)
  • Secured Overnight Financing Rate (SOFR)
  • Prime interest rates

Simple vs. Compound Interest

Simple interest calculates the amount of interest owed on a static principal balance. In contrast, compounding interest adds the current period interest to the principal balance to calculate the next period’s total interest.   

Simple Interest Calculation

The formula to calculate simple interest is the following:

SI = P x R x T

The formula to calculate the total balance owed with principal and interest is the following:

A = P(1 + rt)

A = Amount due
P = Principal borrowed
R = Annual interest rate
T = Time in Years
SI = Simple interest

Example

John borrows $20,000 from his parents. He agrees to repay the loan in 2 years plus simple interest of 6% per year. John calculates the simple interest owed and the total repayment amount below.

$2,400 = $20,000 x .06 x 2

John will owe $2,400 in simple interest expense on the loan. John calculates the total repayment amount as follows:

$22,400 = 20,000 [1 + (.06)(2)]

The total amount of money John must repay to his parents is $22,400.

Compound Interest Calculation

The formula to calculate compound is the following:

CI = [P x (1 + R)^T] – P

The formula to calculate the total balance owed with principal and compound interest is the following:

A = [P x (1 + R)^T]

A = Amount due
P = Principal borrowed
R = Annual interest rate
T = Time in Years
CI = Compound interest

Example

John borrows $20,000 from his parents. He agrees to repay the loan in 2 years plus compound interest of 6% per year. John calculates the compound interest owed and the total repayment amount below.

$2,472 = [20,000 x (1+.06)^2] – 20,000

John owes $2,472 in compound interest expense on the loan, which is $72 more than the simple interest computation. John calculates the total repayment amount as follows:

$22,472 = 20,000 x (1+.06)^2