The Importance of Understanding Interest

The Importance of Understanding Interest

It’s one thing to know what interest is. It’s another to truly understand how interest works. Understanding interest is so important because it can have a considerable impact on your entire financial picture.

The most important thing to know about interest is that not all types are created equal. The way you calculate interest can drastically alter the results. Taking that into account, let’s discuss the two main types of interest:

1. Simple or Nominal Interest

When you learned about interest in school, simple interest was probably the kind you were first taught. The amount of simple interest is calculated as a percentage of the principal amount. Put another way, with simple interest, the principal amount upon which the interest is calculated is constant.

This is easy to understand when your think about a savings account. Say you deposit $10,000 with an annual interest rate of 5%. Now let’s say you let that $10,000 sit there for 5 years. What would the new amount be? If you said $12,500, then you would be correct. Our deposit (the principal) earned $500 (5% of 10,000) each year for five years. That leaves us with $12,500.

2. Compound Interest

Remember how with simple interest the amount upon which interest is calculated stayed the same (every year it was based on $10,000)? Well, with compound interest, that amount continues to accumulate on itself. Compound interest is calculated based on the principal amount and any past interest earned.¹ The earned interest is simply added to the original principal amount at a predetermined rate (annually, monthly, etc.).

Compound interest might be better understood by example. Let’s look back at our savings account scenario once again. This time, however, let’s say at the end of each year your earned interest is added back to the original principal amount. After year 1, just like with simple interest, you would have earned $500 in interest. This time, though, the difference is that $500 is now added to the $10,000. So the following year’s principal becomes $10,500 and that year’s interest is calculated based on that new figure. This process repeats itself every year for 5 years. At the end of 5 years, with interest compounding at a yearly rate, we would actually end up with $12,763, leaving us with $263 more than simple interest.

$263 is hardly an impressive extra profit but hold that thought. Let’s say you let that $10,000 sit for 10 years instead of 5. In that case, the simple interest would leave you with $15,000. On the other hand, compound interest would leave you with $16,288. That’s an extra profit of $1,288! As you can see, allowing compound interest to build and grow over a longer period of time can make a big difference.

Just ask Warren Buffett how powerful compound interest can be:

“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” — Warren Buffett²

Most of us are not Warren Buffet. The beauty of compound interest, though, is that anyone can take advantage of its financial power. Whether you have a mortgage, are repaying student loans, or even depositing money in a bank account, interest has the power to add to your debt or help build your savings. Knowing what interest is won’t help you truly take advantage. Rather, it’s understanding how it can best work for you.¹ https://www.investor.gov/glossary/glossary_terms/compound-interest
² https://archive.fortune.com/2010/06/15/news/newsmakers/Warren_Buffett_Pledge_Letter.fortune/index.htmLife Events