Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds. When money is borrowed, interest is typically paid to the lender as a percentage of the principal, the amount owed to the lender. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate. A bank deposit will earn interest because the bank is paying for the use of the deposited funds. Here, we discussed 2 types of risk: 1) Simple Interest
2) Compound Interest
1) Simple Interest: Simple interest is the most basic type of interest. In order to understand how various types of transactions work, it helps to have a complete understanding of simple interest. The simple interest formula is used to calculate the interest accrued on a loan or savings account that has simple interest. The simple interest formula is fairly simple to compute and to remember as principal time’s rate times time. An example of a simple interest calculation would be a 3 year saving account at a 10% rate with an original balance of TK 10,000. By inputting these variables into the formula, TK. 10,000 times 10% times 3 years would be TK 3000. The formula of simple interest is: [pic]
P is the loan amount
I is the interest rate
N is the duration of the loan, using number of periods
TK TK (% Per Year) (Years)
Simple interest is money earned or paid that does not have compounding. Compounding is the effect of earning interest on the interest that was previously earned. As shown in the previous example, no amount was earned on the interest that was earned in prior years. As with any financial formula, it is important that rate and time are appropriately measured in relation to one another. If the time is in months, then the rate would need to be the monthly rate and not the annual rate. Simple Interest Limitations
Simple interest is a very basic way of looking at interest. In fact, your interest – whether you’re paying it or earning it – is usually calculated using different methods. However, simple interest is a good start that gives us a general idea of what a loan will cost or what an investment will give us. The main limitation that you should keep in mind is that simple interest does not take compounding into account. 2) Compound interest: Compound interest arises when interest is added to the principal, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. A bank account, for example, may have its interest compounded every year: in this case, an account with 1000 initial principal and 20% interest per year would have a balance of TK 1200 at the end of the first year, TK 1440 at the end of the second year, and so on. Here the formula below, i is the effective interest rate per period. FV and PV represent the future and present value of a sum. n represents the number of periods. These are the most basic formulas:
The above calculates the future value (FV) of an investment's present value (PV) accruing at a fixed interest rate (i) for n periods. [pic]
The above calculates what present value (PV) would be needed to produce a certain future value (FV) if interest (i) accrues for n periods. [pic]
Why Compound Interest is The Path to Wealth?
The sooner you start to save, the greater the benefit of compound interest. Compound interest is the interest earned on reinvested interest, in addition to the original amount invested. It assumes that you invested TK 100 at 10% (same as above). The first column is the amount of money you have at a given year if you earned simple interest. The second column is the amount of money...