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August 03, 2022

Understanding the Differences Between Simple vs. Compound Interest

If you financed your car, own any credit cards, are paying back student loans, or have bought a house, you’re probably paying some type of interest on your balances. Do you know if they’re simple interest rates or compounded interest?

What Is Simple Interest?

Interest is an additional fee that you pay on top of any balances you owe. If you have accounts that earn interest, like investment accounts or high-yield savings accounts, your accounts earn additional money based on their interest rate. A simple interest rate doesn’t increase over time. Whether it’s charged monthly, quarterly, or annually, the simple interest percentage stays the same for the duration of your loan or account contract.

Your financed car loan might have a simple interest fee. Let’s say you’re paying off your $40,000 car over a period of five years, and there’s a simple interest rate of 10%. The 10% interest would be based off the principal balance of the car, which is $40,000. It won’t matter if you take the full five years to pay it off or if you pay it off in four years because you’ll still pay the same amount in total simple interest.

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How Do You Calculate Simple Interest?

Calculating simple interest is fairly easy. You’ll need to know the principal balance you owe on the loan or account, the simple interest rate, and the time of the loan agreement. Once you’ve gathered that information, you can multiply those three numbers together to calculate simple interest on the debt owed. Use this simple interest equation the next time you’re trying to find out how much you interest owe:

I = Prt

In the above equation, “I” is the simple interest. “P” is the principal balance you owe at the time. “r” is the simple interest rate in decimal form. “t” is the length of your loan’s term. If we use the car loan example from earlier, the equation would like this:

I = ($40,000)(0.10)(5 years)
I = $20,000 in simple interest

So, while the car’s price was only $40,000, your entire loan amount would be $60,000 because of the simple interest you have to pay.

What Types of Accounts Include Simple Interest?

Some financial institutions use the simple-interest model on certain loan types like:

  • Car loans. Like the example provided above, car loans are typically designed with simple interest rates. When you pay your car note, you usually pay off the loan’s interest first and then pay off the principal balance later down the line.
  • Short-term personal loans. Some short-term personal loans include simple interest until you pay the loan off. In this case, the “t” in the equation might be a number of days or number of months depending on the length of your loan’s contract.
  • Short-term retail loans. Some retail stores partner with financial institutions to give short-term loans to their customers. These loans have term lengths that are usually less than two years and require monthly or biweekly payments, along with the simple interest, until they’re paid off.

What Is Compound Interest?

Compound interest is an interest fee that adds up overtime. It includes the interest rate charged to the principal balance, and it includes the additional interest that’s accumulated from previous payment periods. Your credit card interest is typically compounded daily. If you don’t pay off your credit card at the end of each month, you’ll be paying more interest as time continues.

How Do You Calculate Compound Interest?

Calculating complex interest doesn’t have to be hard. You’ll need the principal balance you owe, the annual interest rate for the loan or account, the length of the loan’s term, and the number of payment periods that have passed while carrying a balance. The equation to calculate compound interest is:

I = P(1+r/n)nt – P

In the above equation,

“I” is the amount of the compound interest owed in the exact time. “P” is the principal balance owed at the time. “r” is the annual interest rate in decimal form. “n” refers to how many payment periods the interest has been accumulating. “t” is how long the money has been borrowed.

For example, if you borrow a student loan for $10,000, and it has a 4% annual compound interest rate for a 10-year loan term, you can calculate your total compound interest if you make on-time monthly payments. If you use the above equation, it should look like this:

I = P(1 + r/n)nt – P
I = $10,000(1 + 0.04/12)(12)(10) – $10,000

In the above equation, use the number 12 for “n” because there’s 12 months in a year, and the compounding interest rate is annual. “t” is 10 because the loan term is 10 years. Use order of operations, also known as PEMDAS, to finish the calculation. When you do so, you’ll get:

I = $10,000(1 + 0.04/12)(12)(10) – $10,000
I = $10,000(12.04/12)120 – $10,000
I = $10,000(1.490832682) – $10,000
I = $14908.32682 – $10,000
I = $4,908.32682

Because it’s currency, we’ll round the compound interest owed to two decimal places at $4,908.33. The amount of compound interest you could pay also varies on if you miss any payments, make late payments, or if you pay less or more than your agreed upon monthly payments.

What Types of Accounts Use Compound Interest?

Some of your accounts that might use compound interest are:

  • Credit card accounts. Check with your credit card issuers to see if interest is compounded daily or monthly. Use your compound interest rate and the balance of your credit card to determine if it’s worth saving money to pay off the entire debt at once or paying off the credit card balance in smaller payments.
  • Student loans. Like the example above shows, you can end up paying thousands of dollars in compound interest when you pay off your student loans. Student loans compound interest daily or monthly depending on the lender too.
  • Home mortgage loans. While mortgage loans are typically paired with simple interest, some lenders use compounded interest clauses. Check your loan agreement to see which interest type your home mortgage loan uses and how often the interest is charged.
“The main differences between simple vs. compound interest are how much interest you’ll end up paying and how long you’ll be paying the interest.”

The Main Differences Between Simple vs. Compound Interest

The main differences between simple vs. compound interest are how much interest you’ll end up paying and how long you’ll be paying the interest. Simple interest is a one-time interest charge based on the principal balance and loan term. Compound interest is an on-going interest charge based on the principal balance, loan term, and existing interest. However, these concepts don’t only apply to loans. You can benefit from earned simple and compound interest charges on investment accounts, savings accounts, and checking accounts.

How Do You Choose Between Simple and Compound Interest?

Sometimes, you don’t have a choice on whether your account uses simple or compounded interest. The lenders and financial institutions usually make that decision based on the type of account you have. However, when you do get to decide between simple and compound interest, remember the following tips:

  • Simple interest is better if you’re borrowing money. The interest doesn’t add up, and once you pay it off, you’ll only have to worry about the principal balance afterwards.
  • Compound interest is better if you’re the one making money from it. CDs, high-yield savings accounts, bonds, and stocks are some examples of how you can earn extra money from compound interest.

Consider how much debt you have, how much money you’ve invested and will plan on adding, how long the term is, and what the interest rate is when deciding between simple and compounded interest. Be realistic about how much of any debt you can pay each month to help lower the compounded interest that is charged. Save up money to make additional payments on simple interest accounts.

When you know the differences between simple vs. compound interest, you know how to use them to save money and make money. Use the equations to calculate the interest of your loans and bills, so you can factor that into your monthly budget to stay on track financially. Researching different budgeting tips can also help you get on track and stay ahead in your finances.

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