If you are an owner/manager of Rent to own company, there is a good chance that you are going to be dealing with "loans" at some point in time. You will most likely be borrowing money from a bank, investor, or yourself. The general ledger account to use when borrowing money is called Notes Payable and is located in the "liability" section of the Balance Sheet. Or, on the other hand, the company might be the lender. The company may make loans to the owner, an employee, or for some other reason. The general ledger account used for lending money is called Notes Receivable and is located in the "asset" section of the Balance Sheet.

During the loan process, the question of an appropriate interest rate will need to be addressed. At that point, you may have to decide whether to use "simple" or "compound" interest depending on the factors of the loan. Often, I have found that clients are confused about the difference between the two interest methods and when it is appropriate to select one or the other. Hence, the following discussion:

There are three parts you must know in order to figure out interest:

1. The principal (amount being borrowed).
2. The rate of interest (usually expressed as a percentage)
3. The time or length of the note (usually stated in years, months or days).

For example: Let’s say you borrowed $1,000 for one year at 10%. The equation is simple: $1,000 x 10% = $100. It is assumed that if you held this note for one full year, you would owe the lender $100. This is almost a no-brainer, right? But, what happens if you borrow the money for less than a year, or for more than a year? Now you need more information.

If you borrow money for less than a year, it is customary to use "simple" interest. Here is why: If a loan is paid off within a year the lender has the opportunity to reinvest the funds and make more money; or, if you borrow money for more than a year, the lender does not have that opportunity so interest owed on the loan is added to principal and then interest is earned on interest. This is called compounding interest and can be done annually, semi-annually, quarterly, bi-weekly, weekly, daily, or any agreed upon time frame.

Simple interest normally uses a 360-day year for simplicity, i.e., 30 day months. Interest calculated this way earns a little more than if using a 365-day year. Here is an example for a 90 day loan:

Ordinary Interest = 360-day year:

$1,000 x 10% = $100 divided by 360 days = .277 cents per day x 90 = $24.93

Exact Interest = 365-day year

$1000 x 10% = $100 divided by 365 days = .273 cents per day x 90 = $24.57

Sometimes all you know is the starting date of the loan and the ending date. Therefore, you will have to count the number of days in between. It may help to remember the little rhyme:

Thirty days hath September,
April, June, and November;
All the rest have thirty-one,
Excepting February alone,
Which hath but twenty-eight, in fine,
Till leap year gives it twenty-nine.

A note written on June 15 and ending on August 14 would be how many days?

Compound interest uses a 365-day year in its calculation. Here is an example:   

Simple interest would be calculated as $4,000 x 5% = $200 x 5 yrs = $1,000. You can see that the compound interest method earns $105.12 more than the simple interest method.

I would encourage you to visit my website at http://www.reallifeaccounting.com and click on "Financial Calculators" where you will find a whole menu of calculation formulas that you can use to help determine a course of action. They are free to use, so please take advantage.