For some of us, interest can be stress-inducing, a reminder of how much we’ll have to pay over the life of our credit card debt or loans. But it’s not all bad. When it comes to saving and investing, interest can potentially make you a lot of money.
Depending on the interest rate and whether or not it is compounded, interest may be directly related to how quickly you are able to grow your wealth.
It’s worth accounting for the significant differences between simple versus compound interest, since the amount of money you could earn can vary greatly.
Understanding the ways in which interest rates can work both for and against you is an important step in helping to secure your future financial stability.
If you’re interested in investing and making your money work harder for you, then identifying interest types and finding ways to earn as much interest as possible could be the difference in thousands, tens of thousands, and even hundreds of thousands of dollars over the course of your life.
Ahead, we’ll break down some of the important basics of interest, including the main differences between simple versus compound interest, how interest rates can impact your investments and savings, and how to calculate interest rates and projections so that you have the opportunity to earn more.
What Is Simple Interest?
When you put money into an average savings account, chances are you are accruing a small amount of simple interest. According to the FDIC, the current average national interest rate for savings accounts is 0.09 annual percentage yield (APY).
APY is the annual rate of return that accounts for compounding interest. APY assumes that the funds will be in the investment cycle for a year, hence the name “annual yield.”
If your interest rate is low, you might be missing out on cash that could otherwise be in your pocket. And it may be worthwhile to look into other types of accounts that could earn you more interest.
In basic terms, simple interest is the amount of money you are able to earn after you have initially invested a certain amount of money, referred to as the principal. Simple interest works by adding a percentage of the principal—the interest—to the principal, which increases the amount of your initial investment over time.
It’s important to note that this goes both ways, and can also apply to debts owed.
While the idea of a growing an initial investment may sound good, depending on the interest rate, simple interest can take a while to significantly grow your money. To calculate your interest rate, you may use the formula I = Prt, where I is the amount of interest, P is the principal, r is the interest rate, and t is the time, in years.
You can also use a simple interest rate calculator online to estimate and project your earnings.
For example, let’s say you were to put $1,000 into a savings account that earned an interest rate of 1%. At the end of a year, without adding or taking out any additional money, your savings would grow to $1,010.00.
In other words, multiplying the principal by the interest rate gives you a simple interest payment of $10. If you had a longer time frame, say five years, then you’d have $1,050.00.
Though these interest yields are nothing to scoff at, simple interest rates are often not the best way to grow wealth. Since simple interest is paid out as it is earned and isn’t integrated into your account’s interest-earning balance, it’s difficult to make headway.
So each year you will continue to be paid interest, but only on your principal—not on the new amount after interest has been added.
Now, let’s take a look at compound interest and how it might be a more effective option.
What Is Compound Interest?
Given how small earnings can be when relying solely on simple interest, getting to know how compound interest works can be the difference between a close-to-flatlined savings or investment account and a flourishing one.
Unlike simple interest, compound interest incorporates the amount of interest earned into your initial investment, so that you are earning interest not only on your principal but also on any interest you’ve made up until that point.
Depending on the type of account you have or what your exact circumstances are, your interest may compound at different rates. Interest typically compounds either daily, monthly, quarterly, biannually, or yearly. The more often your interest compounds, the more money you stand to earn.
To calculate a compound interest rate, you can use the formula P×(1+r) t−P where P refers to the principal amount, R refers to the annual interest rate, and t equals the number of years that the interest rate is applied.
If you aren’t so into math, there are also many free compound interest rate calculators online that can project your earnings for you.
To illustrate how this works, let’s say you invest the same $1,000 at an interest rate of 1%, compounding monthly for one year. At the end of the year, you’d have $1,010.05, which is slightly more than what you’d have earned with simple interest.
Within a lengthier time frame of five years, you’d have $1,051.25. In other words, because you took advantage of compound interest, you wound up with an extra $1.25 in your pocket, without doing any additional work to grow your principal.
The difference between these two may not seem that significant, but there are many instances that can allow you to grow your earnings even more, such as regularly contributing money into your account, and choosing an interest rate that compounds more often.
For instance, if this same investment were to compound daily, 365 times over the course of a year, you’d end up with a final balance of $1,051.27 at the end of the year.
The more frequently your interest compounds, and the more regularly you contribute, the more money you may stand to make. It’s also worth noting that these calculations are based on examples where an initial principal was left untouched, without any additional financial contributions being added, which is typically not how people grow wealth over time.
Simple Interest versus Compound Interest
Now that we’ve covered the basic fundamentals of simple and compound interest, let’s take a look at how the differences between the two may play out in your financial life.
When comparing simple and compound interest, simple interest can often be a lot easier to wrap your head around, and that’s because many everyday financial situations involve simple interest.
For example, in many cases, such as when you’re dealing with mortgages, car loans, or other loans where interest does not compound, you can keep things simple and don’t have to worry about how compounding will affect your principal. After all, in many of these cases, interest is only added to your outstanding principal balance—generally a good thing, as you don’t want to owe more.
While compounding has the potential to grow the value of an asset a lot quicker than with simple interest, it can also rapidly increase the amount of money you owe on some loans, since your interest grows on top of both your unpaid principal as well as previous interest charges.
Things like student loans, which can sometimes compound daily, are an example of how compound interest can quickly work against you.
In the world of investment, however, compound interest reigns supreme as it allows investors to grow their money much faster than they could by leaving their money sitting in an account that earns simple interest.
Using Interest to Grow Your Savings and Investments
When it comes to investing, compounding can hold great potential for an investor. After all, through the process of compounding, an asset’s earnings can be reinvested to significantly increase investment earnings over time.
One way you might begin to increase your potential earnings is to invest early. Because compound interest grows over time, the sooner you invest, the more you may stand to earn in your lifetime.
On top of this, it can be wise to get into the habit of saving money regularly. And if you’re trying to get the most out of compound interest, you may want to reconsider letting it languish in your bank account.
After all, although saving is a part of investing, there’s a major difference between the two. It’s worth considering when it might be time for you to take a portion of those funds—the part that you want to set aside for long-term gain—and buy assets.
Depending on your situation, how much you would like to earn, and the level of risk you are comfortable taking on, this could mean investing in mutual or exchange traded funds (ETFs), buying stocks and bonds, or looking into other investment options.
The way compound interest impacts your investments will depend on the type of asset, interest rates, and how often your interest is compounded.
Another possible way to increase the potential for growth with compound interest is to reinvest dividends—buying additional shares of stock with the money you receive.
On many trading platforms, you can opt into dividend reinvestment automatically. This can provide additional dividends, which may result in additional growth and a better return on investment.
No matter what you choose to invest in, or how you prefer to go about investing, having at least one investment account and starting to contribute regularly is usually step one.
This way, you can start to get a feel for how compound interest works for yourself. The sooner you get started, the more you could potentially earn in the long run.
Investing can seem complicated at first, but by taking the first steps to educate yourself, familiarizing yourself with the powerful potential of compound interest, and getting your feet wet by exploring investment opportunities, you may be setting yourself up to earn more than you could with a traditional savings account.
Once you get started on your investment journey you may realize that, with the help of compound interest, growing wealth doesn’t have to be as hard as you might’ve thought.
No two individuals are alike, and neither are their financial circumstances and long-term goals. For this reason, consider your options when it comes to investment strategies, and don’t be afraid to do your studying and see what possibilities are out there.
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