Anyone who takes out a loan has to think about the cost of doing so. If you need to borrow money to finance a home purchase or a renovation, you’ll want your interest rate to be as low as possible. From an investors’ standpoint, however, higher interest rates present the opportunity to earn higher rates of return. Interest can be simple or it can compound over time. Don’t understand the difference between simple and compound interest? We’ll define both concepts andgive plenty of examples.
Do you have questions about how to optimize your finances? Speak to a financial advisor today.
What Is Simple Interest?
The term interest indicates how much you can earn from the money you originally invest. As your investment sits in an account over time, interest accumulates and you can watch your funds grow.
To calculate the amount of simple interest you stand to earn as an investor, you can use the following formula: Principal Balance x Interest Rate. You can then multiply the product by the number of years you’re investing your money to find out what your return rate would look likeover time.
For example, if you decide to invest $2,000 in a money market account with a simple interest rate of 8.5%, you’ll earn $170 in interest after one year ($2,000 x 0.085). After five years, you’ll earn $850 (170 x 5) in interest.
What Is Compound Interest?
Compound interest represents the amount you earn from your initial investment in addition to the interest you earn – on top of the interest that has already accrued. You can calculate compound interest using the formula, A=P(1+r/n)nt. A is the amount you have after compounding. The value P is the principal balance. The value ris the interest rate (expressed as a decimal),n is the number of times that interest compounds per year and t is the number of years.
Interest can compoundeither frequently (daily or monthly) or infrequently (quarterly, once a year or biannually). The more often your interest compounds, the more interest you’ll earn on your investment.
It’s easy to see that money grows more quickly when it’s earning compound interest than when it’s earning simple interest. To return to the example above, if you invest $2,000 at an interest rate of 8.5% compounding twice a year for 5 years, your end balance will be $3,032.43. You will have earned $1,032.43 in interest, compared to $850 in the simple interest example.
But if that same investment compounds monthly (12 times a year) instead of twice a year, you’ll end up with a balance of $3,054.60. As you can see, the frequency of compounding makes adifference in terms of your overall return rate. If you want to take advantage of compound interest, it’s a good idea to find out how often your interest will compound before you invest your money.
Simple Interest vs. Compound Interest: What’s the Difference?
Compared to compound interest, simple interest is easier to calculate and easier to understand. If you have a temporary loan or one with interest that doesn’t compound, you’ll only have to worry about interest added onto the outstanding principal balance.With mortgages and most car loans, for example, simple interest accrues but does not compound.
When it comes to investing, compound interest is better since it allows funds to grow at a faster rate than they would in an account with a simple interest rate. Compound interest comes into play when you’re calculating the annual percentage yield. That’s the annual rate of return or the annual cost of borrowing money.
If borrowerscan pay off their interest in a shorter period of time, they can then begin paying off their principal loan balance. They’ll be able to pay off their debt more quickly if they’re paying more interest up front.
At the same, if a borrower has a loan that compounds often at a high interest rate, they’ll have higher monthly payments that might not be affordable. In that situation, a borrower might need to consider refinancing the loan to try to get a lower interest rate. For instance, if you’re in the process of paying off your private student loans, you can reach out to a lender to see if you can qualify for a reduced rate.
Bottom Line
Understanding the difference between simple and compound interest is crucial when you’re trying to pick the the right loan or find the best place to store your savings. If you’re a borrower who doesn’t want to get stuck with expensive debt that takes years to eliminate, you’ll probably want a loan with interest that doesn’t compound. But if you’re an investor looking to earn lots of money that you can use in retirement, it’s best to search for an account with interest that compoundsfrequently.
Financial Planning Tips
- A financial advisor can help you put together a financial plan to secure your future.SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can also try building your own financial plan. To start, check out SmartAsset’s guide to building a family financial plan.
Photo credit:©iStock.com/solidcolours, ©iStock.com/TwilightEye, ©iStock.com/MachineHeadz
