What is Interest: Simple vs. Compound interest explained

Your financial health is important. You only need to understand a few key concepts to evaluate your current financial status. These resources are free and available to you here. In this article, we discuss ‘interests’. To understand what interest is we must first begin with two key elements of economics, principal and time.

Let’s say, you have saved up an amount of spare cash that you decided you will now invest. You decided to purchase into a CD with your local bank. You may feel that you are new to the world of investing and think that a certificate of deposit from your local bank is a good place to start. Your bank offers CDs with a minimum purchase of $1,000 for 3 months, 6-months, 12-months or longer. Since your uncertain what your financial demands will be in the future you decide to purchase a CD for just 12 months. For a minimum investment of $1,000 for a 12-month period, suppose the interest rate offered is 2.5%. Enthusiastic and with healthy optimism for the future you accept the banks terms for the agreement.

Here, the principal is $1,000, because it is the original purchase amount of the agreement. The amount of time this investment will be held is called the period. In this scenario, the period for the bank CD is 12-months. Because the interest rate is 2.5% the total interest earned after the loan period is $25.

What is Simple Interest?

Now you understand how a basic loan works. For a certain amount of money, the principal, you agree to loan your money for a specified duration of time, the period, where you will earn a return on your investment based on the agreed interest-rate. In fact, you already know what simple interest is. Simple interest is amount earned based on a percentage-rate paid at the end of an investments’ maturity time.

What is Compound Interest?

Compound interest is very similar to simple interest with only one distinction. In our scenario, a bank CD was purchased for one year. There are instances in real world scenario when an investment is held longer than the time agreed upon. In these instances, the investor has not withdrawn their investment from the bank and although the term has expired the bank will make the assumption that the investor intends to reinvest. In this case, the principal and all earned interests are reinvested on the same terms, in other words at the same rate. Interest is then earned on the original principal and its interest earned; this is compound interest.

We’ll apply this to our scenario. Suppose one year has passed since opening a CD account with bank. Congratulations! You have made $25 return on your 12-month investment. You are eligible to withdraw your earnings, however, you think to yourself how well the year has gone for you. Perhaps you received a raise, or perhaps you have been saving more money. For whatever reason you feel good about your financial health and decide to reinvest for another year at the same rate. The new principal is $1,025 which will be held for another 12-month period for a 2.5% interest rate. In one year, your original investment of $1,000 will grow to $1050.63.

Strategic Financial Management

Building up your money will take time. Having an asset where it can grow uninterrupted means compound interests can have a greater role. Have a plan, also, realize that wealth-building is a long-term commitment. Above all, any planning where you end up having more money in the long-term with much insight in the short-term is wise money management. Also, be sure to read your financial institutions term of agreements before making any financial decision. This information is not intended as financial advice.

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