On the surface, an interest rate is just a number. How this number applies to debt or equity opens up a world of possibilities. The first consideration is always whether it is simple interest or compound interest. Depending on which one you are dealing with, the results for your wealth can be very different.
Simple interest and compound interest are two very different concepts. Although they both represent accumulation, the method accumulation is different. For example, you would like your credit card to use simple interest to calculate your balance instead of compound interest! Likewise, you probably don’t want to invest too much in bonds that offer a return calculated by simple interest.
Let’s get to know simple and compound interest: what makes them different and how they apply to investments, both positively and negatively.
What is simple interest?
Simple interest is the calculation of the cost of a loan or total return on an uncompounded capital balance. This means that the principal balance does not change: no interest payment composes it over the life of the loan or investment. This is the most basic form of interest and it remains static.
Simple interest tends to benefit borrowers because it is not compounded. Instead of accumulating exponential fees over the life of a loan, you pay a known amount of interest on the original amount borrowed. As the loan balance decreases each month, the interest also decreases, as it is fixed on the outstanding balance.
Simple interest formula
The simple interest formula is as simple as you can imagine: I = Prt, or:
- I = total value of interest
- P = main value
- r = interest rate
- t = period
Examples of simple interests
- A certificate of deposit (CD) will produce a return on investment based on the amount of capital invested. The return is not compounded, and the interest rate and term are both fixed. If you invest $ 10,000 in a 2% CD for one year, your return will be $ 200.
- Auto loans amortize monthly, which means you know the principal and interest payments up front. If you buy a car for $ 20,000 at 6% interest for 60 months, you will owe a total of $ 3,200 in interest. Your monthly payment will remain fixed at ~ $ 387.
What is compound interest?
Compound interest is an investor’s best friend. This type of interest returns to the capital to create a larger balance which is able to generate higher returns in each compounding period. The longer the investment and the higher the interest rate, the more potential it has to create wealth.
Compound interest benefits long-term investors. Even if the interest rate fluctuates over time, there is a longer path to creating exponential growth. It is also possible to accelerate the composition with a continuous principal investment or by reinvestments, such as dividends. Compounding puts your money at your service.
Compound interest formula
The formula for compound interest is more complex than simple interest: P (1 + r / n)NT, or:
- P = the balance of the initial capital
- r = the interest rate
- m = the number of times the interest is applied
- t = the number of elapsed time periods
Examples of compound interest
- An index fund will create compound growth over time. If you invest $ 5,000 and keep investing an additional $ 250 each month for 40 years at an average interest rate of 8%, your final compounded amount will be almost $ 1 million!
- Want to create your own example of compound interest at work? Check out our compound interest calculator to see what happens to an investment when you adjust the principal, time horizon, interest rate, and more.
Pay attention to the main
Whether simple or compound, principal has a huge effect on the power of interest rates. For simple interest rates, the principal will determine the net return on your investment or the cost of borrowing. For compound investments or debt, the higher the capital, the faster the rate of accumulation.
Investors need to know interest rates regardless of which side of the financial transaction they are on. Consider the relationship between the amount of money in question and the interest rate that goes with it. In doing so, you will have the power to calculate things like return on investment or internal rate of return (IRR).
Know the best method to accumulate wealth
You will likely encounter both types of interest during your time as an investor. The key is to know what will benefit you the most in the context of your investment vehicle: simple interest vs. compound interest. If you’re looking for a low-risk, short-term investment, you might settle for simple interest. If you are looking for large gains over a long period of time, compound interest is where it is.
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Your access to simple or compound interest will depend on the mode of investment. Good luck finding bonds with compound interest opportunities! Likewise, beware of the cumulative power of debt. Take the time to understand the nature of the interest behind the number and how it affects your principal. Then do everything you can to maximize (or minimize) the effects of interest on your investment.