Investors who put their money into savings vehicles and other accounts hope to earn decent returns. Over time, interest adds up and how quickly it grows depends on the kind of interest you’re working with. If you’re trying to choose between an investment that comes with simple interest and another that has compounding interest, it helps to understand the difference between the two. If you’re in that predicament, we’ve got everything you need to know about simple interest.
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How Does Simple Interest Work?
What is simple interest? It’s the amount of interest you earn from making an initial investment. From the perspective of a borrower paying off a mortgage loan or a car loan, it’s the interest that’s charged on an unpaid principal loan balance. With simple interest, there’s no compounding involved (more on that later).
Suppose you’ve decided to stash $10,000 in a savings account with a simple interest rate of 1%. To find out how much interest you’ll earn in three years, you can use the following formula: Principal Balance x Interest Rate x Time. When your three-year period ends, you’ll find yourself with $300 in interest.
The basic simple interest formula is one tool you can use when you’re looking at multiple investment options, like money market accounts or traditional savings accounts. It’s particularly useful for anyone looking at a short-term investment that you’re not holding on to for years at a time.
If you’re an investor, it makes sense to want a higher interest rate and a higher return on your investment. If you’re a borrower, however, it’s best to stay away from loans that accrue interest too quickly and force you to make expensive payments on a monthly basis.
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The Difference Between Simple Interest and Compound Interest
Compound interest doesn’t only look at the percentage of interest that gets added onto a one-time investment. It also accounts for the interest that grows on top of existing interest. The compound interest formula looks like this: [P (1 + i)n] – P.
When you’re calculating compound interest, you’ll start by adding one to your interest rate (i). Then you’ll raise that sum by the number of times your investment compounds (n). You’ll multiply all of that by your principal (P) and then subtract your principal balance.
With compounding interest, you’ll earn more interest in less time. That’s not the case with simple interest, which doesn’t measure the interest you’ll earn on top of the interest you’ve already earned in the past.
Here’s another example. Maybe you’ve found a certificate of deposit (CD) that earns simple interest at a rate of 0.27% and one that earns compound interest at a rate of 0.2% each month. If you plan to save $5,000 in CD, which one will leave you with the most interest after two years?
Related Article: What Is a Certificate of Deposit?
If you go with the CD with a simple interest rate, you’ll have $27 in interest. On the other hand, if you go with the CD with compounding interest, you’ll have $164.43 in interest after two years. How’s that for the power of compounding?
Bottom line: If you’re investing because you want to have enough money to spend on a weekend getaway or you want to finally start an emergency fund, it’s a good idea to look for an account or fund with compound interest.
The Problem With Simple Interest
The great thing about simple interest is that it’s so simple. You won’t have to crunch too many numbers to find out how much simple interest you’ll end up with after a length of time. But there are issues with relying on it.
If you have a loan, for example, and you’re trying to find out how much money you’ll be paying, calculating simple interest won’t tell you exactly what you’ll be sending off to your lender. That’s because the simple interest formula fails to take into account other things like the fees you’ll be expected to pay up. So if you’re trying to determine the total cost of taking out a loan, you’d be better off looking at the annual percentage rate or even the annual percentage yield, which factors in compound interest.
Similarly, as an investor, simple interest won’t give you a clear sense of how much interest you’ll have since it only builds on your original investment.
The Bottom Line
Simple interest gives you a basic understanding of how much interest you can expect to receive from investing your money. Despite its simplicity, it won’t give you the big picture. Ultimately, it can’t accurately tell you how much interest you’ll earn on an investment or owe to a lender. However, a basic savings account that uses simple interest can still be a valuable financial tool.
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