Practical Application: Borrowing
When a friend, family member or bank lends you money, they are taking a risk that you might not pay back the loan. Interest is a commonly accepted way of compensating lenders for the risk they take in lending. In many cases, borrowing money from a bank may involve compound interest.
Melissa wants to open a small bakery and needs a loan to buy equipment, supplies and to hire staff. Based on her business plan, she thinks the bakery will start to make substantial profits after four years of operation. Melissa asks for a loan from Johan, an old friend, who runs a bakery in a nearby city. In addition to the simple interest loan, they agree to meet monthly to discuss the progress of Melissa’s bakery.
Melissa and Johan agree to the following terms. Johan will loan $100,000 to Melissa for four years at an interest rate of five percent. How much interest will Melissa have to pay at the end of the loan?
I = P r t
I= (100,000) (0.05) (4)
I = 20,000
Melissa will have to pay $20,000 in interest in addition to the principal of the loan, $100,000, at the end of the loan.