Interest in money matters refers to a service charge on the principle amount issued to the borrower. Essentially, if one entity borrowed money from another entity, the borrower will pay back the initial amount borrowed and an extra amount as determined in the form of interest. It becomes an expense to the person who borrows it while it’s a benefit or income to the person who lends out the money. Interest is always charged at a determined rate over a period of time depending on the terms of agreement. On the other hand, principal refers to the actual amount of money borrowed minus any accruing charges. Interest is calculated periodically and it can be calculated monthly or annually.
Across history, interest has been approached in different societies using diverse moral concepts. In places like ancient Greece, statesmen like Solon are known for arguing against the exchange of slaves as compensation for unpaid interest. On the other hand, in the Jewish society, charging interest is/was not viewed as a morally wrong aspect unless issued on money lent to fellow Jew. Additionally, whereas Islam totally forbids issuance of interest, Christianity takes a different angle, only forbidding charging exorbitant interest in what it calls usury. The concept continued to develop in modern economics where it has been enhanced by different theories regarding interest. Adam Smith’s classical theory has been used to explain interest as cost of savings and hence the rate of interest is determined by the supply and demand of capital ( Friedman, 2017). There are two types of interest that can be charged on the principle issued. These are simple interest and compound interest.
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Simple Interest
This type of interest is charged on the actual borrowed amount over the period of repayment. Simple interest is calculated by multiplying the agreed periodic rate with the principle amount by the number of days that elapse between the payments ( Disney and Gathergood, 2013). Its formula and example are as follows:
P – Principal amount.
I-rate of interest
n –number of periods
Simple interest = p*i*n
Example
If one has borrowed $ 8000 from a bank at a rate of 2% for a period of 1 year, the interest accumulated will be 8000*0.02*1 =160.
Simple interest is mostly applied to automobile loans and short term loans and it’s suitable to consumers who pay loans without any delay or before the due day. To anyone who pays the loan before the due day, his/her principle shrinks faster and therefore, enables one to repay money earlier than the original estimate unlike when one makes payment late, most of his/her payment is directed to the interest. Simple interest method can also be suitable for mortgages as used by other banks, who apply the bi-weekly method of payment which helps borrows pay their mortgages in time since they make some extra payments in a year and more time to make payments which results in saving of interests.
Real life Simple Interest loans . A person who takes a simple car loan can be charged interest to repay over a short period. For example, if the total cost of acquiring car is $2500, then the amount that would be loaned as principle ( p ) $2500. If the agreed repayment period ( t ) this loan is 1 year and the interest rate is an annual rate of ( r ) 5% , then the simple interest accrued for this loan will be I=prt which equals $2500 *(5/100)*1= $125. The full repayable amount ( A ) would be A=p (1+rt) $2500 (1+0.05) = $2625.
Another example of the same car loan with the same repayment period but with a monthly rate of 5%, the interest would be calculated as $2500*(5/100)*12 which amounts $1500. The full repayable amount after the period allocated would be calculated as $2500(1+0.6) which translates to $4000.
Compound Interest
It’s the most common method applicable to loans whereby, interest is charged on the principal added together with the interest that has accumulated. The interest accrued over a period plus the initial principle becomes the actual principle that forms the basis of the next repayment period interest calculation. This approach is appreciated more in long-term engagements as the interest is usually plowed back to earn more interest.
Real- life Compound Interest loans. Suppose in a scenario; a business man deposited $ 200 in a bank for a period of 5 years compounded annually at a rate of 10%. The formula for calculating compound interest is I= P (1 + r/n) (nt) - P and the compound amount is A = P(1+r/n)(nt) ; Where A =compound amount, P = principal amount, I =rate of interest and n = number of times interest is compounded, t= period of repayment and r= rate.
The compound interest after five years will be $122.10 while the compounded amount would be $322.10.
Differences and Similarities between Simple and Compound Interest
They both have a cost to the borrower and a return on investment to the issuer. However, compound interest usually attracts more costs or returns than simple interest because of the exponential increase of the principle. Compounding interest involves re-cultivation of the interest into the principle to result in new principle based on accumulated interest. However, with simple interest, the interest is calculated strictly from the actual principal. Consequently, the interest in simple interest is paid in full such that it never accrues while that on compound keeps accruing since it's always added back on the accumulating pricniple. As such, compound interest is usually preferred on long-term repayment structures while simple interest is usually referred when transacting over short-term accounts or loans ( Kreder, and Bauer, 2013 ).
Ethical issues brought about by simple and compound interest
Ethical issues result in a dilemma between two actions that have different consequences to the society. An entity that is in a dilemma over the morality of the choices presented forth is usually in a precarious position of "doomed if you do, damned if you don't." therefore, like any other ethical issue, the morality of interest repayment is subjective. Both simple and compound interest play a big role in enhancing ethics as they help in the promotion of the concept of saving, i.e., people are encouraged to save with the hope of earning more interest on their original money. An example is where one invests $ 100 annually at a 10% interest. Such a person is able to get $110 at the end of the year whether with simple or compound interest. Consequently, such interest helps in promoting the well-being of individuals issuing because it is a source of wealth, and hose receiving since it provides them with good credit for future financing opportunities. .
In conclusion, both simple and compound interests are important aspects of the economy and financial transaction. Even though compound interest might be termed as expensive because of its nature of reinvestment, they both are necessary aspects of money management and investment.
Reference
Disney, R., & Gathergood, J. (2013). Financial literacy and consumer credit portfolios. Journal of Banking & Finance , 37 (7), 2246-2254. Himansu.S.M. 31 ST JUL 2013.
Friedman, M. (2017). Quantity theory of money. The New Palgrave Dictionary of Economics , 1-31.
Kreder, J. A., & Bauer, B. A. (2013). Litigation Finance Ethics: Paying Interest. J. Prof. Law. , 1.
