A financial institution may offer interest payments for opening a new bank account. Lenders might advertise special annual interest rates for a personal loan or credit card. You may consider refinancing a student loan, auto loan or mortgage.
Interest is the cost of borrowing money. Understanding some FAQs and learning about how simple vs compound interest works can help determine whether it is beneficial to fund a bank account or take advantage of a loan.
How Does Simple Interest Work?
The most basic type of interest is simple interest solely based on the principal balance. Simple interest can be calculated with the simple interest formula where the principal is multiplied by the interest rate and period of time.
For example, a simple interest loan for the amount of $1,000 with 10 percent interest assessed once a year would be expressed through the following formula: $1,000 x .10 x 1 = $100. This means the total interest amount after a year on the $1,000 would be $100.
Let’s say that we pay off the loan in a year. An amortization schedule would show an initial interest payment of $8.33 in January and a final interest payment of 73 cents in December. The total interest amount will be just under $55 across equal monthly payments of $87.92 to pay down the total amount of interest plus the principal amount.
Extra payments will reduce the amount of interest while paying down debt more quickly. Alternatively, increasing the repayment period would also increase interest. As we can see, simple interest is not exactly simple.
What Is Compound Interest?
Now that we have examined how simple interest operates, you should know that interest can compound. This means that our totals will be calculated by applying interest rates on top of prior accumulated interest in addition to the principal balance.
Compound interest can be likened to exponential growth. The compound interest formula will necessarily be more complex than calculating simple interest because we must now account for the additional rates of interest that compound on a schedule.
For example, let’s say you have an account with a two percent interest rate that compounds quarterly. You deposit $10,000 into the account and leave it for five years. In your first year, you will earn $201.51 in interest. In year two that amount will be $407.07 and by year five, the account will have earned $1,048.96 in interest.
As you can see, compound interest is not assessed solely on the original principal balance. It is easier to see how confusion about interest can potentially trap consumers in debt.
Benefits of Simple Interest vs. Compound Interest
The key difference between the two types of interest is that the rate for simple interest is constant. Compound interest might be paid on certificates of deposit or savings accounts. Simple interest rates are often issued for bonds.
Compound interest grows much faster than a simple interest rate. The Rule of 72 is a calculation to determine how quickly compound interest can double an initial investment, explains the Corporate Finance Institute. There are also various compound interest calculators available online, such as the one at Investor.gov, that can help with your calculations.
Whether one type of interest is better than the other will depend on each situation and the number of years involved. Most credit cards compound interest daily. This means that a consumer can easily end up paying far more than the principal balance, and this is why the credit reporting bureau Experian recommends paying off the full balance each month.
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.