Interest is the additional amount of money you’re paid for letting someone borrow your money (principal). There are two different types of interest: simple and compound. So, what’s the difference?
Simple interest is as “simple” as it sounds.
You can calculate simple interest with this formula:
Simple interest = Principal amount x interest rate x time
Simple interest is based on the principal amount (which is the amount of money you started with). Real life examples of simple interest would be credit cards or loans.
For example, if someone borrowed $1000 from you at 5% interest for 10 years, you should expect about $500 interest at the end of 10 years after your principal is paid back. While $500 may seem like a decent amount of money, it’s sibling (compound interest) offers more “bang for your buck”.
Compound interest is a little more complicated than simple interest but it’s still easy enough to understand. While simple interest offers linear growth on your investment, compound interest offers exponential growth.
You can calculate compound interest with this formula: A = P x (1+r/n)^nt, where “P” is the principal, “r” is the interest rate, “n” is the number of times the interest is compounded, “t” is for time, usually in years. “A” represents the value of your investment.
Real-life examples of compound interest include a certificate of deposit (CD) or complex loans.
Let’s use the same example from simple interest except apply it to the compounded interest formula.
Now while simple interest is compounded by long the loan is; compound interest is how long the loan is and the number of times it is compounded compound interest. This could range from annually (once) to monthly (12 times). We’ll say that it was compounded monthly (12 times). We should then expect about ~$1283.36. That’s more than double the amount we would have gotten from simple interest! The more that interest compounds, the more you’ll earn from interest. This demonstrates the awesome power of compound interest as it can result in a lot of money.