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In order to prioritize your debt, you need to know where you are paying the highest cost of credit. There can be many different types of costs, but mainly it consists of interest and fees. Fees like origination fees are fixed, but interest can play a significant part in the amount that you pay in the long-run.
Many financial institutions offer credit to their clients as a service. Their clients then pay for the service in the form of interest. In this case, interest is charged on the loan balance. Interest is also the rate that financial institutions pay on deposited amounts. So, you can earn interest and you can pay interest, depending on whether you have a deposit or loan.
Simple and Compound Interest
There are two types of interest: simple interest and compound interested. The distinction between these two types is based on how they are calculated. Understanding the difference between these two forms of interest can help you make informed decisions when it comes to investing and shopping for loan offers.
Understanding the underlying mechanisms behind compound and simple interested is pivotal when you need to know how to decide which loan to pay off first. It will also help you to make an informed investment decision.
Simple Interest
Simple interest is calculated on the principal amount alone.
Simple interest = Principal amount (P) x interest rate (i) x time period (n)
This means that if you pay a loan amount $30,000 over a term of 3 years at an interest rate of 6%, you will have to pay 30,000 x 0.06 x 3 = $5400 interest in total or $1800 per year.
Compound Interest
Compound interest is calculated on the principal amount as well as the interest of previous periods. This means that interest in previous periods forms part of the interest earning amount. Compound interest is calculated as follows:
Compound interest = P[(1 + i)n – 1]
Continuing with the example above:
C.I.= 30 000[(1 + 0.06)^3-1]=$ 5 730.48
30 000 is the principal amount, 0.06 is the interest rate, and 3 is the number of compounding periods. Unlike simple interest, the compound interest per term will not remain the same. Compound interest grows every year since it is calculated on the growth as well as the interest earned in previous periods.
As you can see, there is a significant difference between the simple interest ($5400) and the compound interest ($5730.5).
Compounding Periods
The compounding periods play a significant role in the value of compound interest. The higher the number of compound years, the higher the compound interest will be. For example, a loan amount that is compounded at 10% annually will be lower than a loan amount that is compounded at 5% semi-annually.
This means that if you are depositing money, you would prefer the interest to compound semi-annually. On the other hand, when you have to choose between loan offers, the ones stating that interest will be compounded annually will be more favorable than one stating that interest will be compounded annually. This is also the case of the semi-annual interest is exactly half of the yearly interest.
The Rule of 72
This is a handy method to determine how long your investment will take to double at a given interest rate. Unfortunately, this method can only be used when interest is compounded annually. For example, if you invest any amount at an interest rate of 5%, it means that you can expect your investment to double within 14.4 years (72/5). If you invest at an interest rate of 9%, your investment will double within 8 years (72/9).
Making Interest Work for You
As someone that is economically active, it is incredibly important that you grasp the concepts of compound and simple interest. Interest affect an entire array of everyday transactions and knowing which is best can be incredibly beneficial. Making sure that your investments earn interest that is compounded at regular intervals and boosting the frequency of your loan repayments can make a big difference in your long-term financial well-being.
