Compound interest can be a wonderful thing if you are owed money but can demoralize anyone who owes money. This article is concerned with explaining this financial term so that you have a better idea of how compound interest works and use it to your advantage in daily life.
Simple vs Compounded Interest
When you were young, you likely learned about simple interest; this was an extra amount that was added onto something as compensation for the owed party not having access to the initial amount, usually money. However, the mechanics involved with compound interest are a bit different from those of simple interest.
Simple Interest
Say one of your parents loaned you $500 to buy something fancy for your partner because they love seeing both of you happy. The parent still wants something for their trouble, because $500 is a lot, so they decide to attach interest to the loan. With a simple interest rate of 20%, you would owe your parent a total of $600; the initial amount, also known as a “principal,” was $500 and the other $100 is because that is 20% of 500. On paper, it would not matter how much time had passed, you would owe your parent a total of $600.
Compound Interest
Unlike the previous example of simple interest, compounding interest involves repeatedly applying the agreed-upon interest rate to the collecting amount multiple times. We’ll stick to the same scenario as above but add that the parent has said they would agree to compound the interest at a monthly rate. If you consented to this scenario, you would owe $600 for up to one month after the moment that your parent transferred the funds. If you had somehow failed to pay back any of the money after one month, the amount owed would increase to $720; this is because the compound interest meaning of 20% is applied to both the principal and all prior instances of interest. At the rate and percentage of interest in this scenario, you would owe more than double that initial $500 in just four months ($1,036.84 to be precise).
For a better example of the distinction between simple interest and compound interest, consider this scenario where you take out a $1,000 loan from someone.
- Scenario A: The lender attaches a simple interest rate of 35% to the loan.
- Scenario B: The lender attaches an interest rate of 2%, compounded on a daily basis.
If you agree to scenario A, it means agreeing to pay a flat total of $1,350. With scenario B, you would surpass $1,350 by day 16, owing $1,372.79. This further illustrates that time is money.
To Review
Most banks dealing in compounding interest accounts provide their customers with a compound interest calculator. This is done so that their customers can gain a better insight into how much more money the customers will have or owe after a given amount of time using different compounding interest formulas offered by that bank. When you sit back and look at everything in the world of finance, compounded interest is pretty amazing if someone owes you money; the fact that the amount owed will continue to accumulate until the entire debt is repaid with full interest is a great motivator for encouraging the debtor to clears their debt. Compounded interest is also why it is crucial to go beyond just paying off the principal amount of a loan; yes, the start of the debt may have been handled but it is quite possible that the compounded interest may have eclipsed that amount and will only continue to accumulate.
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