It is our duty to become as knowledgeable as possible about our money and the decisions we make that revolve around it. Whether we are borrowing money or having our money sit in an account, it is important to understand how interest works to ensure we make the best decisions. Simple interest and compound interest are ways money can increase on your accounts. Understanding the differences between them can help you save more money and/or make more money.
Simple interest is interest that is calculated only one time on the original principal balance of a loan. The principal balance is the original amount you borrow. Simple Interest is usually found on auto loans, installments loans, student loans, and mortgages. This type of interest is preferable when borrowing money, but not so much on investments because it would minimize the return on the initial investment. Investment accounts and savings accounts are typically more appealing in an account that accrues compound interest.
Compound interest is interest that is charged to the principal balance as well as any previously applied interest. It Is usually found on credit cards, money market accounts, savings accounts, and CDs. Compound interest is better for you on savings or investment accounts because it increases the return on your money. The return (the interest earned each month) is added to your principal at the end of every period. Each month you earn money on your principal and on the interest you earned in previous months. You earn interest on the interest.
Compound interest is not as good for you on credit card accounts and understanding how it works should open your eyes about why credit card debt can be such a negative thing over a long period of time. Since credit card interest is compounded daily, not only is the interest calculated on your purchases, but it is also calculated on any interest and fees you have accumulated. That’s right!! Interest can be charged on the interest already added to the rollover balance. (The rollover balance is the balance you didn’t pay in the previous month. If you only pay the minimum payment instead of the full balance, you end up “rolling over” the balance to the next month.) This is why it’s so important to pay credit card balances as soon as possible and not rely on only paying the minimum payment.
Both simple interest and compound interest have their benefits depending on the types of accounts you have. Understanding the difference can help you make better financial decisions, understand where your money is going, and how to make it work for you in the most productive ways.