This simple, easy comparison of compound versus simple interest rates includes two tips for maximizing the benefits of compound interest. Financial expert and author Adam Goodman also describes two surprising facts about compound interest…
Before the tips, a quip:
“Many of the biggest and most far-reaching investments we make in our lives are investments that have little or nothing to do with money.” – Daniel Quinn.
That said, most of us do invest our money in something – whether it’s our home mortgage, 401K or RRSPs, or mutual funds. For solid financial advice, click on The Total Money Makeover: A Proven Plan for Financial Fitness by Dave Ramsey. And, read on for Adam Goodman’s description of compound and simple interest, and how interest rates affect investment decisions.
How Compound Interest and Simple Interest Rates Work
The technical definition of compound interest is “interest that is earned on the initial principal and any interest earned on that principal.” Basically, this means interest is calculated on both the initial amount (principal) and any interest earned on top of that initial amount. The best way to show this is through an example, so if you have $10, and each year it earns 10% interest, compounded annually, the first five years would look like this:
How compound interest works:
- Year 1: $10 + 10% = $11
- Year 2: $11 + 10% = $12.1
- Year 3: $12.1 + 10% = $13.31
- Year 4: $13.31 + 10% = $14.64
- Year 5: $14.64 + 10% = $16.11
Each year, interest is earned on the initial amount of $10 (principal) and any interest earned up to that point. Compare this with simple interest, where interest is only earned on the initial principal.
How simple interest works:
- Year 1: $10 + 10% = $11
- Year 2: ($10 + 10%) + $1 = $12
- Year 3: ($10 + 10%) + $2 = $13
- Year 4: ($10 + 10%) + $3 = $14
- Year 5: ($10 + 10%) + $4 = $15
After five years, compound interest earns an additional $1.11 over simple interest. $1.11 may not be a lot of money, but try using the same example with an initial amount of $1,000 or even $10,000, and you can see the power of compound interest!
Can Compound Interest Work Against You?
Like simple interest, compound interest can work both for and against you – it all depends on the situation. If you are borrowing money and the interest is calculated using compound interest, over time, you can expect to pay significantly more than you would if simple interest was used.
When you borrow money, understand how interest is calculated (whether simple or compound interest is used), and how often interest is calculated. Most loans calculate interest on a daily basis, instead of on a monthly or yearly basis – you need to be aware how often interest is calculated. If it’s calculated daily, you’ll pay significantly more in interest than you would if it was calculated monthly or even annually.
Compound interest isn’t all bad! If you’re investing your money, and your investment is calculated using compound interest, you can earn more interest than if it was calculated with simple interest. It’s important to understand how interest is calculated on an investment.
For investment tips, read Tips for Picking and Investing in Stocks.
2 Tips for Maximizing the Benefits of Compound Interest
1. The power of compound interest is time – the more time you have the more money you will earn. To make the best use of compound interest, start saving and investing your money as early as possible. As soon as you start earning money, make sure that you take some money from every paycheck, even if it is only $10, and put it into your savings or investment. The earlier you start, the more money you can earn. This practice is commonly referred to as “paying yourself first.”
2. If you borrow money and interest is calculated with compound interest, pay the money back as soon as possible. This will help you pay as little interest as possible. Some loans will penalize you for paying back the money earlier than what was initially stated – make sure you understand all aspects of your loan agreement before signing it.
2 Surprising Things About Compound Interest
- Credit card companies use compound interest when they determine how much interest you owe each month. For tips on using your credit cards more effectively, read 3 Tips for Managing Credit Cards.
- Compound interest adds up fast! If you invested $1,000 seventy years ago with a return of 5% compounded annually, you would have $30,426.43, whereas the same investment using simple interest would give you $4,500.
For more money tips, read The Benefits of Short-Term Versus Long-Term Investments.
If you have any questions, thoughts, or tips about compound interest, please comment below…
Adam Goodman is the author of Following The Goods: Financial Management for the Young and Ambitious. This book educates and empowers young people on financial management, helping readers understand why they need to care about managing money at a young age.