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Assume that you borrow $2,000 from your sister and that you will pay her back in one lump sum....

Question:

Assume that you borrow $2,000 from your sister and that you will pay her back in one lump sum. She charges you 9 percent interest in 1 year and increases the rate by 1 percent per year until the loan is paid off. How much will you owe if you wait until year 3 to pay off the loan?

Calculating Interest:

Interest is calculated on a loan by multiplying the principal amount and the annual interest rate. If compound interest is used, each interest calculation would be based on both the principal amount and the interest amount accumulated to date.

Answer and Explanation:

If you wait until year 3 to pay off the loan, annual interest would be calculated as follows (assuming compound interest and an interest rate increase of 1% per year starting with 9%):

Year 1 interest = $2,000 * 9% = $180

Year 2 interest = ($2,000 + $180) * 10% = $218

Year 3 interest = ($2,000 + $180 + $218) * 11% = $263.78

At the end of year 3, the total amount owed including interest would be calculated as follows:

Principal + Year 1 interest + Year 2 interest + Year 3 interest

= $2,000 + $180 + $218 + $263.78

= $2,661.78


Learn more about this topic:

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How to Calculate Interest Expense: Formula & Example

from Financial Accounting: Help and Review

Chapter 5 / Lesson 18
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