Interest makes a difference in how wealthy some people are as a result of interest working for them; how poor other people may be based on the amount of money “leaking” from their bank accounts as a result of interest working against them.
Interest can be understood by thinking of interest as a price tag on the use of someone else’s money when borrowed and charged to the user. You would pay interest for the right to use someone else’s cash and when you lend someone else money (put it away in a bank), you would earn interest for that same right to use your money. The rate that you will pay or earn depends on multiple factors including the likelihood that you will repay your debts, the amount of money on the line, and how the money is being used, among others. As a concept, it is simple but the ramifications of this concept are profound.
Take out a loan for something everyday like a car as an example to understand the calculations of simple interest. When you take out a loan from a lender, you basically agree to pay interest on the money you borrow until it is fully paid back. When you are calculating your interest with simple interest, the amount you will pay in interest is calculated only based on the amount you borrow. As such, there will be no surprises, no accumulation of interest on interest and it will be simple to see the math of your loan.
If you’re getting a loan, it will start accruing interest right away; you won’t have to wait a year for it to start collecting interest. You will receive an interest charge in the form of a monthly payment. Therefore, at the beginning of the loan, most of your payment will go to interest, and towards the end, most of your payments will pay down the loan balance. Hence, loans seem to move more slowly at the beginning but are much quicker towards the end.
On the other hand, compound interest occurs when interest no longer waits for you to pay interest; rather, it multiplies based upon the amount of previous interest you have earned. Compound interest is commonly found in savings accounts, investments, and retirement funds; therefore, you will want to see how much you can save by using compounding interest as a method for earning extra money.
Essentially, you save money in a savings account, and then the financial institution pays you interest. The following month, the financial institution will pay you interest not only on your initial deposit but also on the interest that you earned the previous month. The same pattern continues, whereby the financial institution pays you interest on the interest you earned. This process leads to a cumulative effect of interest over time whereby your money will grow/faster than what you could achieve if you were saving money in any other way except through compounding interest.
Debts tend to use simple interest (for example, auto loans, personal loans) because it is easy to determine the amount of interest owned and eventually pay off the interest, as you pay down the debt. Note that the opposite of this is compound interest, which continues to accumulate, grow, and increase while the money is unused. The difference between these types of debts is the same conceptually, but the emotional experience involved with each one is very different.
Time is more important than any other factor when considering interest rates. An investment with a good return over a long time (e.g., stocks) will produce greater returns than an investment with a spectacular return over a very short period of time (e.g., bonds). Therefore, starting early is considered a “cheat code” for investors because it provides compound interest with ample time to accumulate.
While memorizing formulas and being good at math is not necessary to comprehend simple and compound interest, understanding the patterns between both of them is critical to being successful. Simple interest grows slowly, while compound interest grows quickly (explosively) when given adequate time without use.
Take the time to understand the use of simple interest and approach the use of compound interest with extreme reverence, as the time and patience required to effectively utilize the latter will ultimately yield results greater than you could ever produce on your own.
