Most interest calculations that you will encounter are simple interest calculations. In a simple interest calculation, interest is calculated for a defined period of time based on the outstanding balance. Simple interest is used for savings accounts, notes receivable, notes payable, bonds, student loans and lots of other applications. We will discuss how simple interest calculations apply to debt, but the methodology is the same for other applications.

### PRT

The amount of interest charged on a loan is based on three factors: principal, interest rate and time.

Principal is the outstanding balance on a loan. As a loan is paid down, the principal balance decreases. Therefore the interest on the loan also decreases. If the monthly payment on the loan is an equal amount each month, over time, less of the payment will go to interest and more to the principal balance.

The interest rate is the amount of interest charged on the loan. Typically, interest is expressed as an annual percentage rate, also called APR. Although interest is expressed as an annual rate, most loans charge interest monthly. To calculate the monthly rate, divide the annual interest rate by 12.

Time is the duration over which the interest is accruing. If interest is charged monthly, typically we would use the number of days the month divided by 360. Yes, I know there are 365 days in a year, but before calculators and computers, it was much easier to calculate based on 360 days. This became the tradition even after the invention of calculators because banks found they would earn more interest on outstanding debt using 360. Pretty sneaky, huh?

To calculate the amount of interest on a loan, we use this formula:

Interest = P*R*T or Principal * Rate * Time

Example:

On February 1, Technorama borrows \$10,000 from the bank on a 8%, 90-day note with interest due at the time of repayment. How much cash will Technorama need to pay off the note when it comes due?

First, we need to identify our PRT. Principal is the amount borrowed, \$10,000. The rate is 8%. Remember that rates are expressed as an annual rate even though the loan is only for 90 days. The duration of the loan, time, is 90 days. Now we can set up our formula.

Interest = \$10,000 * 8% * 90/360

Interest = \$200

The question asks how much cash will be required to pay off the note. \$200 is not the answer. To pay off the note, Technorama must pay the interest and the principal. Therefore, the cash required is \$10,200.

When doing simple interest calculations, just remember PRT. Always use the annual rate and multiply it by the amount of time for which you are calculating the interest.

## Related pages

double declining depreciation method formulais salaries payable a current liabilitywhat is the purpose of adjusting journal entriesunearned revenue tax treatmentpost closing trial balance definitionperpetual inventory templateretained earnings cash flow statementaccrued income journalpayroll tax wa calculatoraccounting transaction journal entrieshow to calculate principal balanceinvoice journal entrysalvage value calculationprovision for bad and doubtful debts entryplantwide rate formulabond computations straight-line amortizationfederal withholding tax percentage 2014how do you calculate variable cost per unitwhere is unearned revenue recordedtrial balance accounting definitionallowance for doubtful accounts normal balancesalvage calculatorequation for depreciationfinding retained earningstraditional absorption costing examplepayroll tax rate actdiminishing balance method depreciation calculationfifo lifo examplewileyplus costaccounts receivable aging scheduledebit balance and credit balance differencejournal entries depreciationentries for bonds payable and installment note transactionsexamples of operating expenses on income statementstatement of income and retained earnings templatea fixed expensecheckbook reconciliationdebit balance and credit balance differencegross profit fifogross profit on sales is calculated by subtractingjob order costing system examplessalaries and wages payable journal entryaccount receivable is current assetcost of goods sold restaurantformula for contribution margin per unitbank recon samplewhat is office supplies expense in accountingplantwide ratecontra assets examplessalaries payable adjusting entryhow to find contribution marginsimple interest principal formulaperpetual inventory vs periodic inventorywhat is the journal entry for accrued incomeoverhead journal entryweighted average process costing methodaccounting perpetual inventory systemcalculate annuity present valueis accounts receivable debit or credittotal contribution margin at the break even pointpreparing journal entries examplesoverheads costingvariable overhead formulanet sales minus cost of goods soldmaterial costing in cost accountingprepaid rent expense journal entryuses of a trial balancewhat are bank reconciliationsweighted average method accounting formulaprepaid expense journal entryoutstanding deposit definitionexamples of liabilities accountsprovision of doubtful debts journal entriesgross wages vs net wagesnet pay calculator pajanitor payformula for retained earningsprofit margin asset turnoverperpetual inventory lifosimple interest loan payment formularetained earnings carried forward