Simple Interest

The practice of borrowing and lending money dates back in history for thousands of years. Today institutions such as banks, savings and loans, and credit unions are specifically in business to borrow and lend money. They constitute a significant portion of the service sector of the American economy. Interest is the rental fee charged by a lender to a business or an individual for the use of money. The amount of interest charged is determined by three factors: the amount of money being borrowed or invested, known as the principal; the percent of interest charged on the money per year, known as the rate; and the length of time of the loan, known as time. The manner in which the interest is computed is an additional factor that influences the amount of interest. The two most commonly used methods in business today for computing interest are simple and compound. Simple interest means that the interest is calculated only once for the entire time period of the loan. At the end of the time period, the borrower repays the principal plus the interest. Simple interest loans are usually made for short periods of time, such as a few days, weeks, or months. The first method for calculating the time factor is known as exact interest. Exact interest uses 365 days as the time factor denominator. The second method for calculating the time factor is known as ordinary interest. Ordinary interest uses 360 days as the denominator of the time factor. This method dates back to the time before electronic calculators and computers. In the past, when calculating the time factor manually, a denominator of 360 was easier to use than 365. The total payback of principal and interest is known as the maturity value of a loan. The first day of a loan is known as the loan date, and the last day is known as the due date or maturity date. To protect the consumer, the U.S. Congress has passed legislation requiring all lending institutions to quote the true, or effective, interest rate for all loans.