Types of Interest Rate

Understanding Interest Rates

Interest is the cost of borrowing money or the return you earn on your savings.
An Interest rate is expressed as a percentage and annually calculated on the balance of a loan or savings.
Interest rates can significantly impact the overall cost of a loan or the amount of money earned on savings.

There are two types of interest rates: Simple Interest and Compound Interest.

Simple interest is calculated on the principal amount, or initial loan, only.
Interest is gained only on the original amount (the principal) and not on any interest accrued.
The formula for simple interest is: I = PRT, where:
- I stands for Interest earned.
- P stands for Principal (the initial amount).
- R stands for the Interest rate per time period.
- T stands for Time, the amount of time the interest applies to.

Compound interest is interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.
Over time, you earn or owe interest not only on the original amount but also on the interest gained or accrued.
The formula for compound interest is: A = P (1 + r/n)^(nt), where:
- A is the the amount of money accumulated after n years, including interest.
- P is the principal amount (the initial amount).
- r is the annual interest rate (in decimal form).
- n is the number of times that interest is compounded per year.
- t is the number of years the money is invested or borrowed for.

Problem: If you invest £500 at a simple interest rate of 3% per annum for 5 years, how much interest will you earn?
- Solution: Use the simple interest formula I = PRT= £500 x 0.03 x 5 = £75.
Problem: Calculate the compound interest on a deposit of £2000 at 2% per annum, compounded annually, for 3 years.
- Solution: Use the compound interest formula A = P (1 + r/n)^(nt)= £2000 (1 + 0.02/1)^(1*3) = £2124.08. The compound interest will be £2124.08 - £2000 = £124.08.

Understand the difference between simple interest and compound interest.
Practice using the formulas for simple and compound interest.
Remember, simple interest is calculated on the principal amount only, whereas compound interest is calculated on the principal amount as well as any accrued interest.