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Interest - What is interest?

In accounting, interest refers to the cost of money borrowed from a lender. Usually a percentage of the principal amount borrowed, interest can be either simple or compound

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Interest is the amount charged when a debt is incurred through the borrowing of money. Because it can take a business or individual time to pay a debt, interest is often added on a regular basis to encourage fast repayment of the original amount.

The two types of interest

While it seems fairly straightforward, interest charged in a given situation can take one of two different forms: simple interest or compound interest.

Simple interest:

Simple interest is the fast and simple way of determining the amount due on a loan. It is calculated by multiplying the interest rate by the principal by the number of days between dates when payments are made.

Rate x Principal x Number of days = Simple interest

This type of interest is typically used for determining the interest for short-term loans and for car loans.

For example:

  • Shelly takes out a loan that has a principal balance of £5,000
  • The interest rate for her loan is 6%
  • If Shelly’s payment date is March 1st, and is paid exactly on that date, then her interest is calculated based on the 28 days of February, making her interest for the month: £24
  • However, if Shelly pays on February 25th, then her interest is calculated on the 24 days of the month, making her interest: £21

In this equation, the number of days is converted to decimal form as a percentage of the year (28/365 = 0.08) in order to determine the simple interest.

Compound interest:

Compound interest is the more common form of interest charged on loans and will cause the amount to increase much more quickly than in that of simple interest.

Compound interest also involves a more intimidating formula, but essentially it takes the principal amount of the debt and the interest accumulates over time. There are a number of online calculators that are helpful in calculating compound interest. Depending on how often the compound interest is charged, the amounts can differ significantly.

With compound interest, the closing balance for a specified period is carried over to the next opening balance and the interest rate charged on the total amount. This continues through each period, meaning that more periods result in increased compound interest. For example, if the interest compounds once a year, the result is much lower than if it is once a quarter.

For example:

  • If Shelly’s £5,000 loan compounds once a year, the first year would be: £5,300
  • The second year: £5,618
  • The third year: £5,995.08
  • The fourth year: £6,354.78

However, if it compounds quarterly, Shelly’s loan will reach £6,354.78 at the close of the first year.

Why interest is charged

Interest has been around for hundreds of years. It is believed the concept of compound interest arose in 17th century Europe, as a means for the lender to make income on the money lent.

The reasoning behind interest survives to this day. The charge on the loaning of money to either an individual or business is standard practice.

How an interest rate is determined

The interest rate can vary depending on the borrower. There are several important factors that are generally taken into consideration when the rate of interest is determined at the time the loan is issued. In the case of a small business, these include:

  • The total amount requested
  • The credit score/record of the borrower
  • The inflation rate

For example - if Shelly’s business has a trackable record of making payments on time, she will likely be offered a more favourable interest rate than a competitor who has regularly been late in making payments on loans in the past.

Interest and small businesses

It is not uncommon for those just starting out to take a small business loan. Depending on the factors covered above and the type of interest, the loan can fall anywhere on a range of favourable to not ideal.

It’s therefore crucial to keep up with payments and track the progress of repaying debt. In Debitoor invoicing software, you can easily register a small business loan and the regular payments and remaining balance.