Understanding Interest and How to Calculate It
Interest is the cost of borrowing money. When you borrow money, as you do from a bank when you purchase a house or a car, you must repay an amount in addition to the amount you borrowed, and that amount is interest. When you lend money, which is what you are doing when you have an account or a certificate of deposit at a bank, you can earn interest.
Understanding how interest is calculated is a fundamental step both in learning how to borrow responsibly and in growing your investments over time.
Simple versus compound interest and why it makes a difference
Interest is calculated as a percentage of the amount borrowed, which is called the principal. Interest is either simple or compound. Simple interest is calculated only on the principal, while compound interest is interest on the interest.
To illustrate the difference, suppose you have $10,000 invested in a three-year certificate of deposit earning 4% interest. If the bank were to calculate your interest as simple interest, at the end of the first year, you would receive $10,000 x 4% in interest, which equals $400 in interest. You would receive the same amount of interest each year until your CD matured, for a total of $1200 in interest.
If the bank were to calculate your interest as compound, the first year you would receive $400 in interest, just as you would with simple interest. However, the next year the bank would calculate the interest on the principal plus the interest from the first year, so the interest for year two would be calculated on $10,400. At the end of three years, using this compound interest calculator, you can see that the total interest would be $1248.64.
This doesn’t sound like a huge difference until you talk about a longer period of time. If the above example were calculated over 40 years instead of 3 years, the difference between simple and compound interest would be huge. You would receive $38,010.21 versus $16,000 in simple interest. Most banks do calculate interest on a compound, rather than simple, basis.
This incredible return on an original investment is what financial educators mean when they talk about the “power of compound interest.”
You can also use the Rule of 72 to estimate how an investment will grow over time. If you divide the number 72 by the interest rate, it will take that number of years for your investment to double in value. For instance, if your investment’s expected rate of return (interest rate) is 6%, then it would take 12 years for it to double in value: 72 divided by six equals 12.
Compounding frequency matters
In the example above, interest was calculated, or compounded, on an annual basis. Most loans and credit cards are quoted with an annual percentage rate, or APR, which is the cost of borrowing money on an annual basis.
However, interest can be calculated for any period of time. A periodic rate is interest expressed over a specific period. For instance, many credit card issuers calculate interest charges based on a daily periodic rate, which is arrived at by dividing the APR by 365 (or 360, depending on the issuer).
The more frequently interest is compounded, the faster it will grow. So, while it is important to know the APR, it’s also important to know whether interest is being calculated on a daily, monthly, quarterly or yearly basis.
When shopping for a loan, it is also important to see how slight differences in rates and lengths of time can impact the total amount you will pay. Using a calculator can help illustrate how much more interest you will owe when you lengthen the term of your loan or have a higher APR.
Knowledge is key for financial success
Understanding how interest is compounded is an important component of financial success. Personal wealth depends greatly on harnessing the power of compound interest, while also sensibly shopping for credit.
Whether you are considering a large purchase or wanting to learn more about saving for your future, you can make an appointment with an accredited personal financial manager or personal financial counselor at your nearest Family Center.
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