Interest comes into play in many financial interactions, including investing, mortgages, student loans, and so forth. It can raise your investments exponentially into the positive or can make your loans extra pricey. When making financial decisions, it is essential to understand the two types of interest: simple and compound.
Simple interest is precisely that: simple. It is based on the principal or original amount of a loan/investment. To calculate the amount of simple interest you stand to earn in a given amount of time, you can use this formula:
Simple Interest = P × R × N
The variable P is the principal amount, r is the interest rate, and n is the duration of a loan/investment, expressed in years.
To better explain, we’ve put together an example for you in this next section!
Simple Interest Example
Let’s say you take $5000 and invest it in a money market account with an interest rate of 8%; you’ll earn $400 in interest after one year. After 20 years, you’ll make $8000 in interest.
Compound interest is where things get tricky and is a bit more intricate than its counterpart, simple interest. It is interest computed on the sum of an original principal as well as the interest it has accrued. In other words, compound interest is earning interest on interest. And you can calculate it using this formula:
In this case, A is the amount you have after compounding, the variable P is the principal amount, r is the interest rate, n is the number of times that interest compounds per year, and t is the term of your loan/investment, expressed in years.
An important fact to note is that interest can compound annually, quarterly, monthly, or even daily. The rule of thumb is, the more frequent your interest compounds, the more you’ll earn on your investment.
Compound Interest Example
Let’s use our previous example to see how much compound interest will magnify your repayment total.
Again, you’ve taken $5000 and invested it in a money market account with an interest rate of 8%, compounded annually. In the first year, you’ll earn $400. By the twentieth year, $23,304.79. And compared to our previous example with simple interest, you will have made an additional $10,304.79!
But what if that same investment compounds monthly (12 times a year) rather than once a year? You will end up with an extra $1000 and a total of $24,634.01 in your balance. As you can see, you can generate increasingly positive returns depending on how frequently the interest compounds.
Simple versus Compound Interest
While both types of interest will help you grow your wealth over time, simple compared to compound interest is easier to calculate and understand. This makes it an ideal choice if you are a borrower taking out an auto loan or short-term personal loan. With simple interest, you would only have to worry about interest added onto the outstanding principal balance. So whenever you make a payment on a simple interest loan, the payment first goes towards that month’s interest and the rest towards the principal. Then your interest never accrues, and each month’s interest is paid in full.
Compound interest, on the other hand, unlike simple interest, is not the most beneficial choice for borrowers. The downside of compound interest is that it can put you exponentially further into the negative when taking out a loan. This is the case for many types of loans, where you will be paying interest on a balance that includes previously compounded interest. Nevertheless, Albert Einstein once called it the eighth wonder of the world, which is still very befitting. Because while it is not the recommended choice when taking out a loan, compound interest is great for investing and will allow your funds to grow significantly at a faster rate.
Interest can be seen in countless different financial transactions. It’s hard to avoid, but luckily, it’s fairly easy to understand. As its name suggests, simple interest is easy and straightforward, which is what you want when taking out a loan. Although more complicated to calculate, compound interest has the potential to increase your wealth at an incredible rate and, according to Warren Buffet, was his ticket to his financial success. Depending on the situation, you can either work for the interest or, like Buffet, make the interest work for you. Whether you are an investor or borrower, understanding the key differences between simple and compound interest can help you make more sound financial decisions and can help you get one step closer in your journey towards financial independence.