Rahul Iyer
September 17, 2020Compound interest is not a new concept, especially with regards to investment planning. In fact, Benjamin Franklin identified the value of compound interest in the 1700s by saying “money makes money. And the money that money makes, makes money.”
These words shared by one of America’s Founding Fathers lay the foundation for growing wealth through various compound interest ways, such as leveraging a 401(k) plan and savings account.
However, compound interest isn’t the only type of interest out there. Depending on whether you’re borrowing or investing money, simple interest and compound interest offer very different benefits. Here’s all that you need to know about them.
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What Is Interest?
The amount of interest refers to the value of money, or the fee, that a lender earns over and above the value that they initially lent out. Lenders include financial institutions that lend money for the likes of mortgages and student fees.
The interest rate is the percentage charged on the total amount of money that you borrow (or save).
Your desired interest rate will vary depending on whether you’re saving money for the future, or borrowing money for instant use.
There are several instances when interest can affect you.
Borrowing money - the interest rate acts as the fee or cost of borrowing money
Lending money - the interest rate can earn you money in exchange for lending to others
Depositing money - interest-bearing accounts earn interest as your finances are made available for the bank to lend to others
Investments - the interest rate is an indicator of the growth of investments
Simple and compound interest are the two main types of interest. Both follow their own formula and offer advantages and disadvantages. The key is understanding which type of interest is best for you and your circumstance.
Let’s explore the ins and outs of simple and compound interest.
What Is Simple Interest and How Does It Work?
Simple interest is one way of measuring interest on a principal amount. The principal amount refers to the initial size of the loan or investment.
When using simple interest, the interest rate is only applied to the principal amount of the loan or investment at a fixed percentage. Interest is then charged on the loan balance.
As a borrower, simple interest works in your favor as it keeps the overall amount that you owe the lender lower than what compound interest would.
When working out the simple interest formula, consider the following values:
P - principal amount
r - annual interest rate in percentage
n - term of loans (measured in number of years)
With these values in mind, the simple interest formula is straightforward and easy to follow.
Simple interest = P x r x n
For example, if you take out a loan of $100,000 to pay tuition over three years, at an annual interest rate of 5%, then your total loan value can be calculated as follows;
100,000 x .05 x 3 = $15,000 interest
Simple interest loans are most often used with auto loans, student loans, and mortgages. With these types of loans, the overall balance is slowly chipped away each month, as is the interest.
Advantages and Disadvantages of Simple Interest
Now that you understand the basics, you may be wondering: what are the advantages of simple interest?
Simple interest is most beneficial for borrowers.
If you’re planning for a large expense, such as buying a home or a car, then an agreement with simple interest is your best bet.
There are several instances when interest can affect you.
Borrowing money - the interest rate acts as the fee or cost of borrowing money
Lending money - the interest rate can earn you money in exchange for lending to others
Depositing money - interest-bearing accounts earn interest as your finances are made available for the bank to lend to others
Investments - the interest rate is an indicator of the growth of investments
What Is Compound Interest and How Does It Work?
Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Compound interest is calculated on both the principal amount as well as on any interest accumulated on the amount. Simply put, its interest earned on interest already earned.
When using compound interest, the growth of savings and investments accelerates over time. In this way, compound interest can be a powerful force for saving.
In the same way, a loan using compound interest will increase the debt balance over time.
Using compound interest wisely can have a wonderfully positive impact on personal finances. When doing calculations, you’ll have to ask yourself what is the difference between the simple and compound interest formula?
The compound interest formula is slightly more complicated, but follows a straight-forward process. There are different ways to work out compound interest, but all rely on certain values, such as;
A - final amount
P - principal amount
r - nominal annual interest rate in percentage
n - number of compounding periods
t - number of years
Using these values, you can work out compound interest with the following formula;
A = P (1 + r/n)^nt
Let’s put this formula into practice, using the example of a savings account. Imagine you invest $10,000 and plan to grow your money at a high interest rate of 15% over 20 years.
10,000 (1 + 0.15/1)^20 = $16,665.37
Using compound interest wisely can have a wonderfully positive impact on personal finances. When doing calculations, you’ll have to ask yourself what is the difference between the simple and compound interest formula?
There are a few additional interest considerations when calculating compound interest. For example;
Interest rate - a high interest rate is better for investing, and a lower one is better for borrowing
Starting principal - the initial size of the loan or money invested
Compounding period - the frequency of when the interest is compounded (usually daily, monthly, or annually)
Duration - which impacts how much you end up paying back for a loan, or earning on an investment
Deposits and withdrawals - including regular deposits, payments or withdrawals that are made over time
Advantages and Disadvantages of Compound Interest
Just as simple interest has its pros and cons, so does compound interest.
Compound interest is the secret weapon to a successful savings plan, especially when initiated early.
There are several advantages of compound interest, including:
Opportunity to grow your investment quickly with the compound annual growth rate
Potential exponential build-up of total returns
Are you interested in learning how much you can save with compound interest? Find out here.
Sounds too good to be true? It’s important to ask what is the main disadvantage of compound interest.
As a borrower, compound interest can place you in more debt than you realize
Missing a payment deadline adds to the cost
When borrowing money from a bank using compound interest, it’s important to put steps in place to prevent getting in over your head. If the compound interest sneaks up on you, then it’s a good idea to pursue a debt payoff method.
Simple Interest vs. Compound Interest: Similarities and Differences
As you can see, simple and compound interest have unique formulas in order to determine a financial value over and above a principal amount.
Similarities
Although they have their nuances, simple and compound interest share a couple of key similarities.
Both types grow your money as an investor. When an interest rate is applied to a principal value, the final amount will be higher than the initial investment. This is true regardless of compound or simple interest rate.
When borrowing money, both simple and compound interest will increase the amount of money that is owed.
Differences
Simple and compound interest both share a common goal, but they have a few clear-cut differences.
The biggest difference is that simple interest is only applied to the principal amount. While compound interest is applied to the principal amount as well as interest that has already been accrued.
Simple interest is usually used for short-term accounts or loans. Compound interest is most common with long-term accounts and loans.
Finally, the growth of compound interest is quick and exponential. In contrast, simple interest is steady and consistent.
Real-Life Applications and Examples of Interest
The theory of simple and compound interest is great, but how about some real-life examples? Consider the following simple interest vs. compound interest examples that exist in everyday life.
Simple Interest: Car Loans
Although most banks work with some form of compound interest, car loans are usually amortized monthly. Essentially, this means that a portion of the loan is used to pay the outstanding loan balance, and the remainder goes toward the interest payment. In this way, the outstanding loan balance decreases every month, as well as the interest payable.
Simple Interest: Mortgage and Estate
In the United States, mortgages and investing in an estate makes use of a simple interest rate. Each monthly payment eats away at the principal and interest value, reducing the loan balance and the total amount of interest that is owed.
Compound Interest: Retirement
Investing with compound interest savings accounts is one of the most effective ways to build wealth for retirement. In fact, a 401(k) plan that involves investing in stocks and bonds can have lucrative earning potential. To make the most of this compound interest for retirement, it’s important to avoid making withdrawals from your 401(k).
Compound Interest: Investment for Children
Are you considering starting a family? Perhaps you plan to send your children to an excellent tertiary institution? Starting early with a compound interest savings account specifically for your children can open up the funds to give them a quality life with plenty of opportunity.
Frequently Asked Questions About Interest
When making a big financial decision, it’s important to dot all of your i’s and cross all of your t’s. Here are a few common questions about various interest options.
Is Simple or Compound Interest Better?
Simple interest favors the borrower, offering a steady and predictable repayment plan. Compound interest favors the investor, allowing funds to grow at a rapid, exponential rate.
Do Banks Use Simple or Compound Interest?
The exact interest rate and type of interest used by banks will vary depending on the institution (and the individual).
Other compounding interest concepts, such as annual percentage yield (APY) are also used. APY, in particular, is the go-to savings interest rate offered by banks.
Can Compound Interest Make You Rich?
In short, yes. Investing early can grow wealth, regardless of the size of the salary.
Consider the following words by Amber Jamieson, a reporter and author of financial newsletter Better Have My Money, “Compound interest is the way to get rich. Investing is the way to make money. My income will never be that huge, but I can take what I have and make it grow.”
Start Earning With Interest Today
At Lendtable, it’s our mission to see families and communities take charge of their personal finances, build generational wealth and live a high quality of life regardless of socio-economic backgrounds.
Compound interest gives you the opportunity to leverage the likes of ESPP and 401(k) to grow wealth and increase financial freedom.
