When you decide to borrow money – be it to make a purchase of a home or a vehicle – you will be required to pay additional money on top of what you borrowed for the purchase. This additional fee is called “interest”. On the other hand, if you decide to invest money or even just save money like with a money market account or something like a certificate of deposit, you have the ability to earn money. In this comprehensive guide, we will expound on the differences between simple interest and compound interest. Continue reading to learn more.
What is Simple Interest?
Simple interest is an interest calculation method that calculates interest only on the original amount that was either borrowed or invested – also known as the “principal”. It does not include interest that was charged previously. This interest stays fixed as time progresses. It is calculated with a special formula. This is calculated using a special formula. You can use a compund interest calculator, but let’s try to understand it first. This formula is as follows:
Principal x Rate x Time = Simple Interest
In addition to using this formula, you can put the numbers into an online calculator that specializes in calculating simple interest. This is a much quicker method for getting the amount of simple interest there is. As a side note, simple interest is paid and/or received in a fixed percentage of the amount that is designated as the “principal”. This means that the interest typically never changes.
A Simple Interest Example
The following represents an example of simple interest:
Principal: $3000
Interest Rate: 0.075
Time: 5 Years
3000.00 x 0.075 x 5 = $1,125.00
In this example, you would pay a total of $1,125.00 over the course of 5 years with a loan of $3,000.00.
How Does Simple Interest Work?
The interest rate formula that you have been introduced to is used for the most common of debts that consumers take on – vehicle loans, student loans, credit cards, and mortgages. When you borrow, deposit, or lend out money, simple interest may be applied because you have to repay the amount that has been borrowed and pay the cost that the lender charges for borrowing said amount.
All lenders set up an interest rate that is exchanged for borrowing money from, them. Then, there are lenders that allow you to make your own money available to them so that they can make loans for others and these lenders pay you interest.
What is Compound Interest?
If you have ever heard the saying, “Let money work for you”, this is – most often – referring to compound interest. Compound interest is extremely powerful in terms of personal finance. Unfortunately, many people are unsure of what compound interest is and how it works. It is vital that you understand the concept of compound interest. It can make a huge difference when it comes to your investments, your savings, and your overall financial success.
Compound interest is so beneficial that many refer to it as the “eighth wonder of the world”. This is the interest that is possible to earn on your original money – which is referred to as the “principal” and even on the interest that has been added to it. In short, compound interest is actually interest on interest. You earn money on your original money and earn money on the interest that has been added to the original money.
An Example of Compound Interest
To completely understand compound interest, you must compare to it to simple interest. Simple interest – as you learned above – is calculated on only the principal. For example, if you invest $2,000 at 5% of simple interest, you will earn $100 each year. After a decade, you will have earned a total of $1,000. This means that at the end of the 10 years, your investment will grow to $3000.
Now, with compound interest, interest will be added on top of interest. Take the same $2000 at the 5%, compound the interest on an annual basis and at the end of the 10 years, you will have a total of $3,257.79. This is a total of a $1,257.79 surplus – in total.
What is the Rule of 72 in Compound Interest?
There is a very fast way of estimating how long it will actually take for money to double with compound interest. This is the rule of 72. It is a formula that allows you to estimate how much it will double based on the interest rate. You just divide the number 72 by the annual interest rate. For example, if you are earning anywhere from 6% to 10%, it will likely take anywhere from 8 to 12 years.
Real Life Examples of Compound Interest
There are several unique examples of how compound interest works:
- In savings accounts, banks will often offer compound interest on the account, which means they are a great way to grow your money.
- Certificates of Deposit or “CDs” are a great way to grow your financial investments.
- Standard Investments – Many investments, such as bonds, stocks, and other types of investments typically benefit from compounding interest. This is especially true if you take the dividends or the capital gains right back into the account.
- Credit Card and Loans – When it comes to credit cards and loans, compound interest is typically not good. This interest is often charged on balances that are outstanding – as time progresses, the balance that is unpaid will grow in a significant manner. So, with loans and credit cards, compound interest is not at all good.
The Bad Side of Compound Interest
When you owe money, it is important to remember that compound interest can actually work against you. If compound interest is charged on an unpaid balance, that balance will grow as long as you do not pay off your balance each month. When this happens, the debt is harder and harder to pay off. To avoid the bad side of compound interest, you should consider paying more than the minimum balance on the card. If you have debt that carries high interest, you should consider consolidating that debt into a loan with lower interest.
How to Benefit from Compounding Interest
If you want to benefit from compound interest, consider the following:
- Early Investments – To make the most of compound interest, you should start investing early. The more time your investment has to grow, the more money that you will make in the long run. Even the smallest investments allowed to grow for an extended period of time can turn into significant earnings.
- Consistency is Key – You should contribute to your savings account or your investments on a regular basis as consistent as possible can grow your money as time progresses.
- Account Selection – You should look for accounts that actually offer compound interest. Examples include savings accounts, retirement accounts, and other types of investment accounts. The more often that your account compounds – monthly, quarterly, etc. – the faster your money will grow.
- Permit Growth – When an account has compounding interest, you should permit it to grow and avoid taking money out of it. If your money remains untouched, it will multiply nicely over time and your will earn a lot of money on that investment or those investments.
- Dividend Reinvestments – If you have accounts that pay dividends – such as mutual life insurance, stocks, or even mutual funds – you should take those dividends and reinvestment them. This will maximize the compounding interest that you are earnings.
What are Fixed Rates and Variable Rates?
When dealing with interest – be it simple or compounding – it is important to understand that banks will likely charge either a fixed rate or a variable rate as it relates to interest. The following outlines this:
- A fixed rate will remain the same over the entire course of the loan life. This type of rate is often on vehicle loans, mortgages, and even student loans.
- A variable rate are associated with the bank’s prime lending rate. The low rates are given to customers that have good credit. Higher variable (changing) rates are often given to those that have subpar credit. Any changes to the prime lending rate will result in the interest rate of the loan changing. In most instances, the prime rate is changed when the Federal Reserve adjusts the “fed rate”. Loans that have variable rates include credit card debt and mortgages that are identified as “adjustable-rate”.
- If interest rates fall, you may be able to refinance the loan so that you are able to get the best rate possible.
- If the market is going through normal conditions, the variable rate is typically much lower than that of a loan that is a fixed rate loan. This means that variable rate loans are best if they are short-term loans.
- If interest rates rise quickly with a variable rate loan or debt, it could negatively impact your financial situation.
If you would like to learn more about making the most of your finances, contact us here at Somerville Bank at one of our many locations: https://somervillebank.net/locations/
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