Compound Interest: A Term Which Could Save Your Finances

There are quite a few financial literary terms which we all should know and understand. One of these is idea of compound interest. It is a simple term with a rather simple definition and formula. However, if presented to you in the wrong circumstance could mean a much larger hit to your finances.

Simple Interest

There are other forms of interest which are used in the financial world. One of these is simple interest. This particular term and calculation is similar to how its name appears, simple. Most consumers will see this type of interest on their vehicle loans, and it is rather straightforward to calculate. The basic calculation for simple interest is (principal x interest x number of periods = p x i x n). Thus, if you have a principal amount of $5,000 at a rate of 5% annualized over 6 years, your interest amount would be 5,000 x .05 x 6 = $1,500 or $250/year.  This is simple and straight math and relatively easy to understand.

Compound Interest

One of the other forms of interest is compound. In simple interest there is a basic interest amount every year that does not change. In compound interest, there interest amount from the first period is aggregated within the amount of the next interest amount. The aggregation is creates the compounding effect we can see. The calculation of compound interest is (principal x interest value from future periods – principal amount in the present = P [(1 + i)ⁿ – 1].  As it relates to the same example above, we would see a slightly higher interest amount. Therefore, your principal amount a rate do not change, but the periods in which your interest rate is being multiplied does. We see it in 5,000 ((1 + .05)^72) – 1 =$1,745.09. Instead of a straight $250 a year, the monthly interest was constantly changing.  In the first year, the interest amount cumulative was $255.81 and the cumulative interest in the second year was $524.71. These are significant differences as compared to the simple interest.

The Good, The Bad, And The Interest -ing

These rates are common in the marketplace today in different facets. They each provide benefits when used in the right setting. It is important as a consumer to understand the difference between each of these and can recognize how each should be used. For example, you would not want to have your mortgage have a compounding interest payment. The resulting outcome would be astronomical. I calculated the compound interest of our current mortgage for reference, and the interest amount alone would be over $875,000! The opposite is true for investment funds. You would not want to have simple interest on a $500,000 venture. At $500,000 with a 3% rate for 10 years with simple interest would only equate to $15,010 of added interest to your investment. When the investment is properly compounded, the return is approximately $174,676. As you can see, having the right rates at the right time can make a significant difference in your finances.

Understanding interest rates is just another key financial literacy term which is good to know when building your financial foundation. The regulations are in place to safeguard the consumer and ensure we are able to understand what we are getting with loans and investments. However, it will still be your responsibility to understand prior to engaging in any of these forms.