Understanding compound and simple interest

The cost to borrow or loan money, otherwise known as Interest, impacts you every time you take out a loan or make an investment. Interest is expressed as a percentage and represents the cost of borrowing money. So, when you take out a loan, the rate you’re charged represents the fee paid to the lender. Comparatively, when you invest your money, the rate is the fee you make for lending your money to others. 

Interest can either be simple or compound depending on the loan or investment, changing the way the rate is calculated.

Simple interest

Most of us are familiar with simple interest. Student loans and car payments are two examples of this.

Simple interest is always calculated on the principal amount and stays constant throughout the duration of the loan. For example, if you take out a loan for $1,000 at a 10 per cent rate with a five-year term, you will be charged $500 over the duration of the loan. By the end of the term, you will have re-paid $1,500 to your lender with the additional $500 representing the cost of borrowing the principal.

How do you calculate simple interest?

You can calculate simple interest using the expression S = P x R x N. Where P represents the principal amount, R the annual interest rate and N the term of the loan. 

Understanding how simple interest is calculated can help you choose favourable loan terms. This allows you to make better-informed decisions about your finances. For example, if you need a $5,000 loan for home renovations, and Lender A is offering you a four per cent rate with a six-year term, and Lender B is offering you a seven per cent rate with a three-year term, which Lender would you choose?

Under Lender A’s terms, your total payment owed by the end of the term would be $6,200. With Lender B, it would be $6,050. Knowing this difference will help you make a more educated decision about which Lender is best for you.

Compound interest

Investments and credit card debt are two examples of compound interest rate products you might be familiar with. The fees are based on the principal amount plus any interest that you have not paid. For example, if you make only the minimum payment on your credit card, the interest owed is added to your principal balance. On the next billing cycle, you will pay additional fees. Essentially, you are paying (or earning) interest on your fees, as well as on your principle. Alternatively, fees that you earn from investing are added to your balance and can earn even more!

Compounding periods can range from daily to annually. The interest amount increases when you compound more frequently. Compound interest tends to be much more lucrative for investors. Therefore, much more expensive for borrowers compared to simple interest. For example, if you invest $1,000 at a 10 per cent rate that compounds annually, after five years you will have amassed a total of $1,610.

How do you calculate compound interest?

You can calculate compound interest using the expression C = P x (1 + R)T – P. Where P represents the principal amount, R the interest rate, and T the duration of time interest is applied. 

Looks and sounds confusing, right? Knowing how to calculate compound interest helps you make more strategic decisions for investing your money. In addition, you can avoid debt with an aggressive compound rate. It’s important to understand your options when it comes to financial products. A good or bad decision has a significant impact on your financial future!

For example, if you are deciding between two savings accounts from different financial institutions and Institution A offers a two per cent rate that compounds quarterly, and Institution B a three per cent rate that compounds annually, you can use the equation above to determine the most lucrative option. If you were to deposit $2,500 into your savings account and not deposit anything else for 10 years, Institution A would yield a gain of $552 bringing your total savings up to $3,052. Comparatively, Institution B would return a gain of $860 for a total savings of $3,360.

Educate yourself first!

When it comes to taking out loans and investing your money, there are many lenders and institutions to choose from. Comparing the rate types among the different vendors will help you understand your total financial obligations and/or rewards for the total lifespan of the financial commitment. This knowledge will help you make more strategic decisions and keep your finances healthy. By understanding these options, you will ensure that you make the most on your investments, and pay the least on your debts!

Be sure to tune back in throughout the month of November for more from us at Clinton Wilkins Mortgage Team. We are always willing to help answer your questions directly. You can get in touch with us here!