You might have heard of the compound and simple interest when dealing with banks or investments. But what do these words mean? Let's figure it out.
When borrowing, you pay interest (a fee). When saving, banks pay you interest. This interest can be simple or compound. Simple interest is earned on the initial deposit only. Compound interest, however, is a powerful tool that earns interest on both your initial deposit and the accumulated interest over time.
Does it still feel confusing? Worry not. This post teaches every detail about compound interest v/s simple interest, how to calculate them, compounding, and how to benefit from it.
Let's dive deeper!
How to Calculate Simple Interests?
You can easily calculate simple interest by multiplying the principal amount by the annual interest rate and the number of years in the loan term. Here is the formula:
Simple Interest = P x r x n
In this,
- P is the Principal amount
- r is the Annual interest rate
- n is Years of the loan term
The interest rate is always in percentage. So, you can either calculate it directly or divide the amount by 100 to calculate the percentage.
To find out the final amount, use this formula: A = P(1 + rt)
Let's say your savings account has $1000 and the bank pays simple interest of 5% APY, after 5 years your total amount would be $1250 with $250 interest.
How To Calculate Compound Interest?
The word compound means something that consists of two or more things. This simple realization of the word may help you memorize the calculation. We have to add additional interest from the previous periods to calculate the compound interest. Here is the compound interest formula:
Compound Interest = P x (1 + r)t - P
In this formula,
- P is the principal amount
- r is the annual interest rate
- t is the years
You can calculate the final payable amount by using this formula: A = P( 1+r/n)nt
In this, A stands for the final amount.
Calculating compound interest can be overwhelming if you are not a math ninja. However, many websites help you with a compound interest calculator where you can put the value and get the final payable amount or interest calculated.
Let's go with the same example where your savings account has $1000 for 5 years and the interest rate is 8.5% APY compounded annually, the total amount after 5 years would be $1527.3 with a $527.3 interest amount, which is higher than the simple interest amount.
Tips to Make Compound Interest Work for You
- Let Time Do Its Magic: Time is a powerful factor in compounding. The more time you have, the more interest you can accumulate. That's why it's crucial to start investing in your early years for your retirement.
- Instantly Pay Back the Debt: If you have borrowed money from banks or financial institutes with compound interest, you might have to pay more. The faster you pay back the debt, the lower the interest you have to pay.
- Check Compound Periods and Rates: The more the frequency of compound periods, the more interest you will get. Experts suggest choosing daily or weekly compounding periods for investing.
The Bottom Line
Although compounding is a complex concept, you can still take baby steps and earn that extra money on interest and principal value. Invest with Compound real estate bonds and earn 8.5% APY, compounded daily and build your wealth.
