The interest banks pay on deposits is calculated in a fairly complicated manner, so we will start by considering a personal loan to a friend or relative. When you make such a loan, you agree on an amount of the loan (called the principal) and an interest rate. The interest rate is a percentage of the loan amount your friend agrees to pay you for every year she keeps your money. This is called simple interest.

Example. If you loan a friend $1000 and she agrees to pay you simple interest of 5% per year, then for each year she keeps your money you should receive receive an interest payment of

	5
5% $1000 =		$1000 = $50.
	100

If you agree to let her keep the money for 3 years and she agrees to pay back your loan plus all of the interest at that time, then you expect to receive

$1000 [the loan] + 3 years 5%/year ($1000) [the interest] or

$1000 + 3 .05 $1000 = $1000 + $150 = $1150

after 3 years elapse.

Here is an opportunity to check your understanding of simple interest. Select an annual interest rate and a number of years. Then enter the total amount you would receive if a friend paid back the principal and interest on a $1000 loan made for that number of years at the simple interest rate you chose. To check your answer, click on the button.

Select Interest Rate	Select Years	Enter Value
2% 3% 4% 5% 6%	1 year 2 years 3 years 4 years 5 years	With simple interest on a loan of $1000, what is the total principal and interest? $

WORKING BACKWARDS

Problem: Jane loans John $250 for 5 years. At the end of 5 years, John pays Jane $287.50. Assuming this represents the total principal and simple interest on her $250 loan, what rate did he pay?

Solution: To see the solution, open up this pop-up window.

© 1997,1998 Robby Robson, Oregon State University.