Interest is one of the most important money concepts to learn about. Interest is an amount charged on money that is borrowed. It is typically based on a percentage of the amount that was borrowed. You can earn interest on savings accounts or investments, or you can pay interest on loans, credit lines, or a mortgage. Interest can be simple or compound.
Simple interest is when interest is paid based only on the principal amount borrowed. There are only a few real-life situations that utilize simple interest (i.e. certificates of deposit for periods of one year or less). Learning the concept and easy calculation of simple interest can help you to quickly estimate how much interest is involved in a short-term loan, but most loans, lines of credit, savings, and investments involve compound interest.
The formula for calculating simple interest is I = PRT where I = simple interest, P = the principal amount invested or borrowed, R = the interest rate expressed as a decimal, and T = the time involved.
Simple interest = Principal x Rate x Time
Here is an example:
If you invest $1,000 in a one-year certificate of deposit that earns 5% interest, how much will you earn in interest?
Simple interest = 1,000 x 0.05 x 1
= $50 earned interest
Compound interest is interest that accrues for a given time period (i.e. compounding annually, monthly, daily) based on the total amount of principal +accrued interest. As interest accrues on a loan or investment, you will either earn or repay your principal plus any accrued interest.
The formula for compound interest is A = P (1+r/n) ^nt where A = the total future value of principal + interest, P = principal amount either borrowed or invested, r = the annual interest rate expressed as a decimal, n = the number of times interest is compounded per year, and t = the number of years money is invested or borrowed.
Future value = Principal (1 + rate/#of times interest is compounded per year) ^ #of times interest is compounded per year x # of years
This is a more complicated formula, and there are a plethora of compound interest calculators available online, so our below examples are going to highlight the power of compound interest without working through the math by hand. Here is a link to a site that offers handy calculators.
Here are three examples:
If you invest $1,000 in a U.S. Bond earning 2.1% interest (compounded annually) over 5 years time, how much money will you have at the end of the 5 years?
$1,109.50 is your total value, so you’ve earned $109.50 in interest.
If you borrow $20,000 in student loans with an interest rate of 6.8% and plan to repay the loan over 10 years time, approximately how much interest will you pay?
Paying the minimum payment of $230 per month, over 10 years you will pay a total of $27,619, which means you are paying $7,619 in interest.
If you owe $1,500 on a credit card with an 18% interest rate, and you can only make the minimum payment of $25 per month, how long will it take you to pay the balance in full, and how much interest will you be paying?
Paying $50 per month will mean that you will be paying for 41 months. You will pay a total of $2,050, with $550 paid in interest. This is more than 3 years of payments!
Let’s say you could increase your monthly payment to $80.
Paying $80 per month will mean that you will be paying for 23 months. You will pay a total of $1,840, with $340 paid in interest.
Compounded interest means that you will owe more interest on loans and earn more interest on investments. This is what people mean when they talk about letting your money work for you! Learning how interest impacts you in both positive and negative ways can greatly improve your financial decision making and leave you with more money in your pocket.
The reason that we put money into a savings account, CD, bond, or invest in the stock market is to make money when our initial investment gathers interest. Earning compound interest over time is what is enticing about keeping your money in an interest-bearing account, but you’ll want to keep inflation in mind.
Inflation is what people refer to when they say that their money doesn’t go as far as it used to, or they refer to the price of goods 20 years ago versus today. You want the return on your investment to outpace inflation so that you are, in fact, making money on your investment. This is a consideration when investing for a longer-term goal.