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Calculating simple interest and compound interest

From: Excel 2007: Financial Analysis

Video: Calculating simple interest and compound interest

One of the first rules you learn in business is that no one gives you money for free. If you plan to borrow money with the goal of making a profit, you should expect to pay interest so that the institution that loaned you money can make a profit too. There are two main ways to calculate interest, Simple Interest and Compound Interest. Simple Interest is calculated based on the principal, interest rate, and time only. In other words if you pay a loan back over time, the unpaid interest doesn't part of the principal. As an example, take a look at the loan terms we have in this worksheet.

Calculating simple interest and compound interest

One of the first rules you learn in business is that no one gives you money for free. If you plan to borrow money with the goal of making a profit, you should expect to pay interest so that the institution that loaned you money can make a profit too. There are two main ways to calculate interest, Simple Interest and Compound Interest. Simple Interest is calculated based on the principal, interest rate, and time only. In other words if you pay a loan back over time, the unpaid interest doesn't part of the principal. As an example, take a look at the loan terms we have in this worksheet.

We have a principal of $200,000, a rate of 6%, and a term of 5 years. So to calculate the total payment on the loan we'll add the principal to the principal times the rate times the term. And we have $260,000. You can verify that answer is correct. 6% of $200,000 is $12,000. So you multiply that by 5, which would be $60,000, and you have a total of $260,000.

One other scenario that uses simple interest would be in annuity that guarantees a set return each year. Most loans and investments calculate their vales using compound interest. But you might counter simple interest investments, so you should know how to calculate it. Unlike simple interest, investments that use compound interest include previously earned interest when determining how much interest to pay the next time a payment is due. One example would be a certificate of deposit with an annual percentage rate of 6%. So we have the example here in the worksheet and you'll notice that the terms of the loan are exactly the same as we had for the simple interest example.

We have a principal of $200,000, a rate of 6%, and term of 5 years. To calculate the total due over the life of the loan or the life of the investment, you use the formula here in cell D7. You multiply D3, which is the principal, by 1+ the rate, which is 6%. So, that would be 1.06, and you raise 1.06 to the power of 5, which is the number years. So, to calculate the future value of the loan, you type in the formula D3, again the principal, times 1+B4, the rate, raised to the power of the value in B5, the number of years, and press Return.

There you have the future value of the loan. Now, please note that the future value of the investment is $267,645.12, which is greater than the $260,000 result from the simple interest calculation. That is the power compounding interest monthly as opposed to annual and for including previously earned interest in future interest calculations. Now, you might also be called on to evaluate a loan or an investment where interest is compounded continuously and for that you use the formula in cell D9.

So you multiply the principal in cell B3 in this case, by the natural logarithm, and this is a function that you use to calculate it. The math is fairly advanced. You don't really to know it. You just need to know how to calculate continuously compounded interest. But you multiply B4, the rate, by B5, the term. There you have your answer, $269,971.76.

Calculating compound interest is one of the skills you use frequently in financial analysis.

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Excel 2007: Financial Analysis

51 video lessons · 13859 viewers

Curt Frye
Author

 
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  1. 2m 6s
    1. Welcome
      1m 8s
    2. Using the exercise files
      32s
    3. Disclaimer
      26s
  2. 13m 20s
    1. Separating inputs and formulas
      2m 2s
    2. Avoiding common mistakes
      5m 39s
    3. Tracing formula precedents and dependents
      2m 52s
    4. Evaluating Excel formulas step by step
      2m 47s
  3. 18m 40s
    1. Tracking income and expenses using an Excel table
      3m 29s
    2. Creating a Pivot Table from table data
      3m 36s
    3. Pivoting a Pivot Table
      2m 22s
    4. Filtering a Pivot Table
      3m 11s
    5. Adding Pivot Table columns to enhance data analysis
      3m 5s
    6. Tracking cash flow using a Pivot Chart
      2m 57s
  4. 18m 48s
    1. Reading a corporate financial statement
      6m 1s
    2. Introducing common-sizing strategies for analyzing financial statements
      3m 59s
    3. Creating common-sized income statements
      3m 1s
    4. Creating common-sized balance sheets
      2m 53s
    5. Calculating percentage changes in financial statements
      2m 54s
  5. 8m 12s
    1. Calculating earnings per share
      1m 54s
    2. Calculating return on equity and return on assets
      2m 50s
    3. Calculating gross profit margin and net profit margin
      3m 28s
  6. 6m 19s
    1. Calculating the current ratio and quick ratio
      2m 47s
    2. Calculating the average collection period
      1m 56s
    3. Calculating inventory turnover
      1m 36s
  7. 6m 12s
    1. Calculating the equity ratio
      1m 26s
    2. Calculating the debt ratio
      2m 57s
    3. Calculating the times interest earned ratio
      1m 49s
  8. 10m 58s
    1. Calculating simple interest and compound interest
      3m 36s
    2. Applying nominal versus effective interest rates (APR versus APY)
      3m 21s
    3. Calculating the number of days between events
      4m 1s
  9. 13m 32s
    1. Computing the future value of an investment
      3m 30s
    2. Calculating present value
      2m 29s
    3. Calculating net present value
      2m 42s
    4. Calculating internal rate of return
      2m 24s
    5. Calculating NPV and IRR for uneven input periods (XNPV and XIRR)
      2m 27s
  10. 7m 30s
    1. Projecting future results using the Forecast function
      2m 9s
    2. Performing quick forecasts using the Fill handle
      2m 57s
    3. Adding a trendline to a chart
      2m 24s
  11. 22m 28s
    1. Introducing amortization
      2m 20s
    2. Calculating payments on a fully amortized loan
      2m 21s
    3. Calculating payments on a partially amortized loan (balloon payments)
      2m 4s
    4. Calculating interest and principal components of loan repayments
      5m 32s
    5. Introducing depreciation
      2m 1s
    6. Calculating straight line depreciation
      1m 30s
    7. Calculating declining balance depreciation
      3m 24s
    8. Calculating double declining balance depreciation
      3m 16s
  12. 9m 34s
    1. Introducing bonds and bond terminology
      1m 37s
    2. Calculating a bond's yield
      2m 15s
    3. Calculating the value of zero coupon bonds
      3m 18s
    4. Pricing bonds to be offered to investors
      2m 24s
  13. 23s
    1. Goodbye
      23s

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