The Major terms of loans are :
1-Loan value.2-Interest value.
3-Time.
To define them very will, let us consider the following example :
Pop wants to borrow 200$ from a lender called john, John said ' i'll give you 200$ (NOW) but you have to pay it back to me after (ONE year), the total amount you will have to pay is 400$ '.
in the last example The Major Terms values was :
1-Loan Value =200$ at the begining (Now)
2-Interest Value = 400$ - 200$ = 200$ (At The End Of The Year )
3-Time = One Year
Infact, John rented the time for 200$ for One year (considering that he lend only 200$ as a loan,if he lend more, the time price will raise).
The rental value is called Interest, it is allways referred to as a rate of the amount owed per period of time.
If we say :
15%/year , the Interest will be 15% of the total amount owed for one year.
1.5%/month,the interest will be 1.5% of the total amount owed for one month.
Infact, there are two major types of interest which are :
1-Simple Interest.
2-compound Interest.
There is a big defference between those types above.
To deffer between them let us consider the following example for a 1000$ owed for 5 years and 15%/year as (1)simple interest and (2)compound interest.
(1) Simple Interest :
Here, we can say that the total amount of interest at the end of the 5 years is15%/year * 5 year * 1000$ = 750$
so the borrwer should pay 1000$ + 750$ =1750$ at the end of the 5th year.
it is called a simple because we could calculate the value of the interest directly.
(2) Compound Interest :
Here, there is no more simple calculations for interest, and we have to calculate each period alone then find the sum of the total interest.The basic principle of this kind of interest is :
At the end of each compounding period (which is here one year , we could conclude that from the term 15%/year ) the interest is calculated then adds to the total amount owed, thus at the end of the following compounding period, the interest will be calculated on the total amount ( amount owed plus the interest from the previous period). Or in one sentence ( pay interest on the previous interest ).
To simplify more let us solve the previous example using compound Interest :
at the end of year one :
total amount owed =1000$
total compound interest = 1000$ * 0.15 = 150$
at the end of year two :
total amount owed =1000$ + 150$ = 1150$
total compund interest = 1150$ * 0.15 = 172.5$
at the end of year three :
total amount owed =1150$ + 172.5$ =1322.5
total compound interest = 1322.5$ * 0.15 = 198.375$
at the end of year four :
total amount owed =1322.5$ + 198.375$ = 1520.875 $
total compound interest = 1520.875$ * 0.15 = 228.13125$
at the end of year five :
total amount owed =1520.875$ + 228.13125$
=1749.00625
total compound interest = 1749.00625$ * 0.15 = 262.351$
the total amount should be paid at the end of the 5th year is :
1749.00625$ + 262.351$ = 2011.3571875 $ .
Interest is compounded each period of time specified by the term ( Interest % / period ) unfortunatly , simple interest is not used anymore by the lenders.
From now on all calculations will be based on the "compound interest", because it is the only one used by the most of lenders.
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