Compound Interest Vs. Simple Interest | What's the difference?

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December 1, 2022

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You might have heard of the compound and simple interest when dealing with banks or investments. But what do these words mean? Let's figure it out. 

Interest is the fee a borrower pays to a lender for a loan. Simply put, the calculation of the interest is either simple or compound. Well, as the name suggests, simple interest is simple to calculate. It's based on the face value or principle amount and the period of the load. On the other hand, calculating compound interest is a bit complex. In this type of interest, a borrower should pay the interest on the principal amount and interest. 

Does it still feel confusing? Worry not. This post teaches every detail about compound interest v/s simple interest, how to calculate them, compounding, and how to benefit from it. Let's delve deeper! 

How to Calculate Simple and Compound Interests? 

You can easily calculate simple interest by multiplying the principal amount by the annual interest rate and the number of years in the loan term. Here is the formula:

Simple Interest = P x r x n

In this, 

  • P is the Principal amount 
  • r is the Annual interest rate 
  • n is Years of the loan term 

The interest rate is always in percentage. So, you can either calculate it directly or divide the amount by 100 to calculate the percentage. 

To find out the final amount, use this formula: 

A = P(1 + rt)

The word compound means something that consists of two or more things. This simple realization of the word may help you memorize the calculation. We have to add additional interest from the previous periods to calculate the compound interest. Here is the compound interest formula: 

Compound Interest = P x (1 + r)t - P

In this formula, 

  • P is the principal amount 
  • r is the annual interest rate
  • t is the years

You can calculate the final payable amount by using this formula: 

A = P( 1+r/n)nt 

In this, A stands for the final amount. 

Calculating compound interest can be overwhelming if you are not a math ninja. However, many websites help you with a compound interest calculator where you can put the value and get the final payable amount or interest calculated. We suggest relying on an official website of the United States government to calculate compound interest. 

What is Compounding?

Compounding is a process of earning through interest on interest or capital gains and revisiting that amount to generate additional income. It's an increasing asset value due to the interest earned on the principal and already accumulated interest. 

Investors choose this process to grow their savings quickly and earn on both the principal amount and the interest. On the other hand, banks use it to receive the principal amount quickly. The more you delay repaying the initial amount, the more you have to pay. In short, compounding is beneficial for investors but not for borrowers. 

The more compounding periods in a year, the more interest will accumulate. The compounding period is the time between two interest dates. Annual compounding means you will receive the interest only once a year and be compounded again in the next year. So, when you are investing, you should look for more compounding periods. Simply put, the more compounding periods in a year, the better the investment. 

If you want to study how compounding works and how you can benefit from it, we suggest studying Warren Buffett's strategies. He used compounding as a wealth-building tool. 

What is A Compound Interest Account?

The account that provides interest on the principal amount with interest on interest is a compound interest account. It can be a savings account, zero-coupon account, money market account, and so on. 

Which Types of Accounts Offer Compound Interest?

1. Savings Accounts 

You can have a savings account that offers compound interest. We recommend choosing accounts that compound daily or weekly instead of monthly and annually. That will increase your interest faster, and you can reinvest the money. You can talk to your local bank or create an online account. 

2. Money Market Accounts 

These are similar to savings accounts, except you can withdraw money through an ATM and write checks. Also, it offers a higher interest rate than a savings account. However, there are limits on transactions in a month, and you might have to pay fees if your balance lowers a certain amount. 

3. Dividend stocks

Dividend reinvestment plans let investors reinvest their dividends into more shares. This investment strategy helps you to earn extra interest money and reinvest it without hassle. Many companies offer these programs to investors. 

How to Earn Compound Interest?

Many investing strategies, account types, and options involve compounding. Here are some compounding investments that can help you grow your wealth: 

1. High-Interest Savings Account 

2. Bonds 

3. Stocks 

4. Treasury Securities 

5. Rental Homes 

6. REITs

7. CDs

Before investing, you can discuss these options with your financial adviser or study them thoroughly. 

Tips to Make Compound Interest Work for You 

1. Let Time Do Its Magic 

Time is a powerful factor in compounding. The more time you have, the more interest you can accumulate. That's why it's crucial to start investing in your early years for your retirement. Your retirement funds can grow through compounding while you are enjoying your youth. 

2. Instantly Pay Back the Debt

If you have borrowed money from banks or financial institutes with compound interest, you might have to pay more. The faster you pay back the debt, the lower the interest you have to pay.

3. Check Compound Periods and Rates

The more the frequency of compound periods, the more interest you will get. Experts suggest choosing daily or weekly compounding periods for investing. 

The Bottom Line 

Although compounding is a complex concept, you can still take baby steps and earn that extra money on interest and principal value. A community and like-minded people may help you be an investment master, diversify your portfolio, learn other compounding interest concepts, try new strategies, and more. So, join the Compound Banc community today and learn about property and other investment hacks. 

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