Interest Factor

Interest is a sum of money paid for the use of another amount of money, called the principle. Banks and other financial institutions pay interest to savers for the use of money deposited in savings accounts: borrowers pay interest for the use of money loaned to them. Interest is usually stated as a yearly rate of percentage of the principal involved. Interest was regarded with disfavor in early times. Aristotle thought it evil, a view that persisted through the Middle Ages: religious and secular laws prohibited interest, or usury as it was called. With the growth of commerce and the development of banks, usury came to be viewed merely as exorbitant interest, and governments began to set limits on interest rates.

Simple and Compound Interest
Interest is calculated in two different ways; as simple interest and as compound interest. Simple interest means that the interest payment for the year is the principal amount multiple by the interest rate; for example, the interest on $1000 is $60 if the interest rate is 6%. Most borrowing, leading, and saving use compound interest, however, when compound interest is computed, the basic one year period is divided into smaller periods, and the interest earned in each shorter period is added to the principal amount. Because the principal amount. Because the principal amount becomes larger throughout the year, the total amount of interest paid for the entire year is larger under compound interest than it would be under simple interest.

Interest is usually compounded on a semiannual, quarterly, monthly, or daily basis, which means that earned interest, is added to the principal at the end of every six months, every quarter, every month or every day. For convenience, the interest rate is often stated as a nominal rate compounded at specified periods: 6% compounded monthly, for example. The effective rate, however, is larger than the nominal rate. The effective rate, or the rate actually paid, is illustrated in the following example using $1000 deposit that receives 6% interest (the nominal rate) compounded quarterly.