Compound interest

Simple interest vs compound interest


Simple Interest vs. Compound Interest: An Overview

When analyzing the terms of a loan, it is important to consider more than the interest rate. Two loans can have the same principal amounts, interest rates, and repayment terms, but significant differences in the amount of interest you pay, especially if one of the loans uses simple interest and the other uses simple interest. compound interest.

Key points to remember

  • Simple interest is calculated using only the principal balance of the loan in each period.
  • With compound interest, interest per period is based on the principal balance more any unpaid interest already accrued. Interest builds up over time.
  • The Truth in Lending Act (TILA) requires lenders to disclose the terms of the loan to potential borrowers, including the total amount of interest to be repaid over the life of the loan and whether the interest is simply accruing or compounding.

Simple interest

Simple interest is calculated using only the principal balance of the loan. Typically, simple interest paid or received over a certain period is a fixed percentage of the principal amount that has been borrowed or loaned. For example, suppose a student gets a simple interest loan to pay off a year of his tuition, which costs $ 18,000, and the annual interest rate on his loan is 6%. They repay their loan over three years.

The Truth in Lending Act (TILA) requires lenders to disclose the terms of the loan to potential borrowers, including the total amount of interest to be repaid over the life of the loan and whether the interest is simply accruing or compounding.

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Compound interest

With compound interest, interest per period is based on the principal balance plus any unpaid interest already accrued. Interest builds up over time. When calculating compound interest, the number of compounding periods makes a significant difference. As a general rule, the greater the number of compounding periods, the greater the amount of compound interest. Thus, for every $ 100 of a loan over a certain period, the amount of interest accrued at 10% annually will be less than interest accrued at 5% semi-annually, which in turn will be less than interest accrued at 2.5%. . quarterly.

In addition to scrutinizing the The truth about loans statement, a quick math calculation tells you whether you’re looking for simple or compound interest.

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72

Compound interest leads to the “Rule of 72,” a quick and useful formula that is commonly used to estimate the number of years it takes to double the money invested at a given annual rate of return.

Key differences

Suppose you borrow $ 10,000 at an annual interest rate of 10%, with principal and interest owed as a lump sum over three years. Using a simple interest calculation, 10% of the principal balance is added to your repayment amount in each of the three years. This works out to $ 1,000 per year, which represents $ 3,000 in interest over the life of the loan. On reimbursement, the amount due is then $ 13,000.

Now suppose you take out the same loan, with the same terms, but the interest is compounded annually. In the first year, the 10% interest rate is calculated only from the principal amount of $ 10,000. Once done, the total outstanding balance, principal plus interest, is $ 11,000. The difference is felt during the second year. Interest for that year is based on the full $ 11,000 you currently owe, rather than the principal balance of $ 10,000. At the end of the second year, you owe $ 12,100, which becomes the basis for calculating the third year interest. When the loan matures, instead of $ 13,000, you owe $ 13,310. While you might not consider $ 310 to be a huge difference, this example is only a three-year loan; compound interest accumulates and becomes oppressive with longer loan terms.

Another factor to watch out for is how often interest is compounded. In the example above, this is once a year. However, if it is compounded more frequently, such as semi-annually, quarterly, or monthly, the difference between compound interest and simple interest increases. More frequent compounding means the base from which new interest charges are calculated grows faster.

Another easy way to determine if your loan uses simple or compound interest is to compare its interest rate to its annual percentage rate, which TILA also requires lenders to disclose.The Annual Percentage Rate (APR) converts the finance charge on your loan, which includes all interest and fees, into a simple interest rate. A substantial difference between the interest rate and the APR means one or both things: your loan uses compound interest, or it has a high loan fee on top of the interest.

The bottom line

In real life situations, compound interest is often a factor in business transactions, investments, and financial products intended to span multiple periods or years. Simple interest is mostly used for easy calculations: it’s usually for a single period or less than a year, but it also applies to open situations, like credit card balances.

Make the magic of compounding work for you by investing regularly and increasing the frequency of your loan repayments. Familiarizing yourself with the basic concepts of simple and compound interest will help you make better financial decisions, save you thousands of dollars, and increase your net worth over time.