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CHAPTER 10INTEREST RATES (MAKING MONEY WHILE YOU SLEEP)

Interest is the cost of using someone else's money. If you borrow money, you have to pay back the amount borrowed plus interest. If you lend money, you will get your money back plus interest.

Simple Interest

Simple interest is, indeed, very simple. If you lend someone \$10,000 and you are to be paid 7 percent simple interest, you will receive \$700 in interest payments for each year that the loan is outstanding.

If you make a five-year loan, for example, you will receive the following interest payments each year:

• Year 1: \$10,000 × 7 percent = \$700
• Year 2: \$10,000 × 7 percent = \$700
• Year 3: \$10,000 × 7 percent = \$700
• Year 4: \$10,000 × 7 percent = \$700
• Year 5: \$10,000 × 7 percent = \$700
• Total interest: \$3,500

The question is: When does the \$3,500 have to be paid?

Some loans require the borrower to make the \$700 interest payments each year (or, alternatively, you may have to pay monthly, which would be \$58.33 per month in this example). That is called current interest.

Other loans allow the borrower to defer or wait to make the interest payments until the end of the five years. In other words, the borrower pays no interest in years 1 to 5 but has to pay the full \$3,500 all at one time when the \$10,000 loan is due. That is called accrued interest.

If it is a simple interest loan, the borrower pays \$3,500 regardless of ...

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