Foundational Knowledge — Compounding Interest and Simple Interest

If you have ever looked into investing or saving money, you have probably seen someone talking or writing about the power of interest (specifically compounding interest). The reason so many people talk about interest is that it makes your money into more money, without you having to do anything.

That is right, free money.

Photo by Burak K on Pexels.com

So, in the case that you have no idea what the two types of interest are, or you want a refresher, this article is for you.

First, let’s start with what interest is. Interest is the money a bank or financial institution will pay you to give them your money. Now, you may be wondering, why would a bank pay me to deposit money into their bank? Well, the bank will take your money and invest it (usually in a very safe place, such as a GIC or a Bond). The bank will make money off of your money, and give you a small portion of the profits.

Banks will offer one of the two types of interest rates. The first being simple interest (this one tends to make you less money), and the second being compounding interest (this one tends to make you more money in the longterm).

Simple interest in common terms is money you earn on what you deposit. Compound interest is money you make on what you have deposited, as well as the money you have already received in interest payments.

So, let’s say you have $100, and you put it in a high-interest savings account that pays you 5% simple interest annually. In one year the bank will pay you $5, and the next year it will pay you the same and will continue to do this until you deposit more money.

Banks will tend to offer higher interest rates on simple interest, but, in the long term, this tends to make you less money than a lower compounding interest rate.

Now, an example of how compounding interest works. Let’s say that the bank is offering you a compounding interest rate of 5% annually (if you find this rate at a bank, take it and run). You deposit $100. After a year, your $100 will turn into $105 (100 X 1.05 = 105). You have made $5 interest. The next year, your money will be worth $110.25 (105 X 1.05 = 110.25), which is an increase of $5.25, not the $5 you made the first year. Why? Because compounding interest works with all of your money, not just the money you have deposited.

It may not seem like much, but, when you use compounding interest on larger sums of money, your payments grow significantly each time you receive interest. Let’s say that it is now $10,000 instead of the $100 in the first example. In the first year, you would earn $500, in the second year, you would earn $525. Over two years you would have earned $1025, which is a 10.25% return on you $10,000.

Compounding interest is a powerful tool that has been used by many of the worlds most successful investors. It is a basic concept that is not only used with high-interest savings accounts but, that is for another day.

The purpose of investing is to use your money to make you more money. Simple interest and compounding interest are powerful and safe tools to start your investment journey.

Use it wisely

3 Comments

  1. I really like the concept of writing about foundational knowledge! Finance should be accessable to all and what you’re doing here is letting new people into the sector. That’s some really admirable work and is a reminder to myself that I should perhaps cover the basics more often within my own writing!

    Like

    1. Thank you! I appreciate your kind words! I think a lot of people that are interested in finance, forget that financial literacy can be a very difficult skill to learn! Hopefully, I can help a few people along the way!

      Liked by 1 person

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