Simple interest is calculated based on the financial account balance only, while compound interest is calculated based on the financial account balance and the accumulated interest from previous periods. This means that compound interest grows the amount owed much faster than simple interest.
One of the first things you learn in money management is the concept of interest that comes into play when borrowing or borrowing money. Lenders earn interest on the money they lend, while borrowers pay interest on the money they borrow. Interest is a percentage of the money you borrow or lend that is paid regularly. Although it is usually quoted annually, the interest can last as long or as short as the lender requires.
It is important for borrowers to note that they will usually pay interest on repayment of the borrowed money. For example, imagine a credit card with an annual percentage (APR) of 1 percent. When you pay your bill, you pay the amount you owe, in addition to the 1 percent interest. This means that you end up paying more than you borrowed.
However, it is important to remember that when there are actually two types of interest, simple or compound interest, interest is usually introduced as simple interest. When the amount of interest you pay increases in an upward curve, compound interest is similar to a snowball effect. Read on to learn more about the difference between the two and how it affects your finances.
What is simple interest?
Interest is a fee that you pay on top of the money you borrowed in repayment, and simple interest is the most basic type of interest you pay. The interest rate doesn’t rise over time, so you always know how much you’re going to pay.
For example, if you had a 5 percent APR credit card that you bought $ 1,000 worth of purchases on, you’d end up paying back the $ 1,000 you borrowed from the credit card company, in addition to 5 percent interest on $ 1,000 – and all of your balance, including pay off the simple interest would cost $ 1,050. Read on to learn how to calculate simple interest.
How to calculate simple interest
Similar to the scenario above, the simple interest calculation involves three elements: the principal, the interest rate, and the term of the loan. The principal is the amount borrowed or loaned, the interest rate is the additional fee, and the term of the loan is how long the money was borrowed or loaned before repayment. Check out the simple interest rate formula below.
Simple interest = Principal x interest rate x term of the loan
What is compound interest?
Compound interest is a charge on a loan or deposit that makes up the principal in addition to interest accrued from previous periods.
You may hear about compound interest called interest payments. Another factor that influences the interest rate is the frequency of compounding. In other words, the greater the number of interest periods, the higher the interest rate.
Calculation of compound interest
When calculating the compound interest, the principal amount is multiplied by one and then the annual interest rate is added to the number of compound interest minus one. As a result, the entire principal is subtracted from the value of the compound interest equation. Find the compound interest formula below.
To easily calculate compound interest, take a look at our compound interest calculator.
Difference between simple and compound interest
What differentiates between simple and compound interest is that the latter grow the amount owed much faster than simple interest. This is because simple interest is calculated based only on the financial account balance, while compound interest is calculated based on the financial account balance and the accumulated interest from previous periods.
Compound interest is the key element that distinguishes between simple and compound interest. Because of this, there is a significant difference in how much interest there is in cases of compound interest. The greater the number of compound interest periods, the higher the compound interest owed.
Real life applications
Here we apply what we have learned to your finances. Simple interest is typically used when taking out credit card loans, auto loans, student loans, consumer loans, and sometimes even mortgages.
On the other hand, compound interest is often used to increase investment returns over the long term, such as: B. 401 (k) s and other attachments. Another common use of compound interest is in bank accounts, especially savings accounts. Student loans, mortgages, and credit cards can also use compound interest. So be sure to pay attention to the interest rate when making big financial decisions like these. There are no hard and fast rules as to which purchases are simple or compound interest. So, ask your lender or do some research before borrowing money.
Understanding simple and compound interest is helpful in taking control of your finances. Whenever you borrow money, it is very likely that interest rates are involved. It is even more important to understand the pros and cons of interest and how to maximize your money management. Whether you’re taking out a car loan, choosing the best credit card, or just want to better understand how interest rates work, you’re off to a good start!