Interest rates are a part of our daily lives, even if we don’t always think of them. Whether you have a mortgage, student loans, or pay on a car loan or credit cards, the interest rates we pay dictate how big of a check we’re writing. But the impact of interest doesn’t stop there; when we open a bank account or make an investment, we hope that it pays a high interest rate so we can make more money. Interest is everywhere – just about as old as money itself – but many people are still confused how it works, including the important difference between the two types of interest: simple and compound.
Simply put, interest is the cost of the money you’re borrowing, or someone is borrowing (or investing) from you. Think of it as a percentage of the total amount over a given period of time. But from there, interest work differently depending on whether they’re simple or compound.
Simple interest:
Simple interest is calculated by multiplying the loan amount but the interest rate by the number of payments over the life of the loan. Most credit cards, car loans, and installment loans are based on simple interest.
The interest rate, say on a credit card, mortgage, etc., is usually expressed as an annual rate, while the total number of payments is usually expressed as a monthly payment (so a 10-year loan would have 120 payments.) So you just have to make sure you’re calculating a yearly payment term if that’s how your interest rate is expressed.
Example:
First year: $1,000 x 1 year x 10% = $100 in interest
Second year: $1,000 x 1 year x 10% = $100 in interest
Total Interest: $200
Total of the principal amount plus interest = $1,200
In this scenario, the total amount of interest paid over the life of the loan would be $200
Compound interest:
With compound interest, the borrower pays not just on the principal (total loan) amount, but also on the interest that has accrued at any given payment. Mortgages are calculated with compound interest.
Even though the payment fluctuates every month, mortgage payments are usually fixed because of the phenomenon of amortization, the ratio of repayment. Each month when you make your fixed mortgage payment, a certain amount goes to pay off interest and the rest goes to paying down the original principal, or loan amount. With mortgages, you’re paying almost all interest the first few years and then start paying off the loan amount faster as time goes on.
Example:
First year: $1,000 x 1 year x 10% = $100 in interest
Second year: $1,100 x 1 year x 10% = $110 in interest
Total Interest: $210
Total of the principal amount plus interest = $1,210
In this scenario, with interest compounded annually, the total amount of interest paid is $210
Now that we’ve covered simple interest and compound interest and understand the difference, there is another consideration: interest rates when you’re the beneficiary. When you open a bank account or invest money in a mutual fund or financial product, you’re actually lending the banks your money, which they will use to do business with other customers. So they’ll pay you an interest rate for the privilege to hold and use your money. We want a good rate of return – or high guaranteed interest rate – on any investment, but that has to be measured out against he potential risk of any investment. Of course there are many variations how interest and rates of return are calculated on a myriad of investments and financial products, so always consult a professional financial planner and read the fine print!
