Long-term investing is one of the best ways to secure your financial future, but navigating this often complicated landscape can feel overwhelming. Understanding how to grow your investment will ensure you get the greatest return on investment (ROI) and make your money work for you.
Investing in an account with an annual interest rate that fits your long-term goals is key, but how do you choose the one that’s best for you?
In this article, we’ll discuss the difference between simple and compound interest and give examples of accounts that use each. With the right tools and education, you can develop a financial strategy that effectively grows your wealth.
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What is Simple Interest?
Simple interest is the money earned solely on your principal investment amount. It does not compound, so any money on which you accumulate interest will not earn interest itself. Simple interest is the most basic type of interest, as it only allows you to earn interest on your initial investment. While your money still grows, this growth is limited and slow.
Simple Interest Example
If you invest in an account with simple interest, it’s important to understand that no matter how much your balance grows from the interest you accrue, you’ll only continue earning off your original deposit amount.
For example, if you make a $100 deposit in a savings account at 5% interest, you’ll have earned $5 at the end of the year. Your new balance will now be $105, but you’ll only continue to earn interest on the initial $100 deposit.
The same concept applies when you borrow money. For example, let’s say you take out a $5,000 loan with a three-year term at a 5% yearly interest rate. At the end of the loan term, you’ll have repaid the initial $5,000 principal amount plus $750 in interest, totaling $5,750.
You can calculate simple interest by multiplying the principal amount ($5,000) by the yearly percentage rate (5%) by the loan term (3):
$5,000 x 0.05 x 3 = $750.
What Types of Accounts Use Simple Interest?
A few types of accounts use simple interest, including savings, loans, and CDs. Basic savings accounts generally use simple interest to incentivize investors to grow their money, but typically offer a lower percentage rate.
It’s also common for auto, student, and personal loans to use simple interest. Since borrowers generally pay them back over shorter periods than a savings account, banks may not need to charge higher interest rates.
Finally, CDs also use simple interest. With a CD, the investor agrees to deposit money into the account for a specified period, generally six months or more. In return, the bank pays out higher interest rates than a typical savings account. It’s important to note that CDs can also accrue penalties if the money is withdrawn before the account matures.
What is Compound Interest?
Accounts with compound interest earn money on the invested amount and the interest earned. Unlike simple interest, where your earnings are only determined by your initial investment, with compound interest, you continue to grow your investment year after year. When your deposit earns interest, that amount is added to your balance to calculate the following year’s interest. The result is accelerated wealth growth since your money is continually growing.
Compound Interest Example
With compound interest, your earnings include the interest earned on your balance year after year. For example, if you deposit the same $100 into a compound interest account with a 5% interest rate, you would have earned $5 the first year, bringing your balance to $105. With the initial deposit, your investment growth is the same as a simple interest account.
However, you start seeing the difference in the second year and beyond. Now, your balance is $105, and with the same 5% interest rate, your earnings are $5.25, bringing your new balance to $110.25. You’ve now earned back 10% of your initial deposit! With a compound interest account, the more you invest, the more you earn, making it one of the best ways to grow wealth quickly.
What Type of Accounts use Compound Interest?
Typically, credit card companies and investment accounts use compound interest. With credit cards, compound interest is applied when users don’t pay their balance in full. These charges are why it’s so easy to get behind on credit card debt.
High-yield investment accounts like retirement and brokerage accounts also use compound interest to maximize the investor’s returns. Investing in an account with compound interest is one of the best ways to grow your financial portfolio and build wealth. Other accounts that may use compound interest include:
- CDs
- Money Market Accounts
- Bond Funds and Bonds
- Savings Accounts
Advantages of Using Compound Interest
There are numerous advantages to investing in an account with compound interest. Since these accounts reinvest your earnings, they grow your balance faster than with simple interest savings. Compound interest can also protect your investment from inflation. When prices go up, your money’s value declines, so earning compounded interest on your investment can ensure your money grows faster than the inflation rate.
Disadvantages of Compound Interest
If you have a loan or credit card account that uses compound interest, it can quickly cause you to fall behind on repayment. If you don’t pay off the entire balance, your interest charges are compounded, raising your balance. This increase can make paying off your debt difficult.
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Is Simple or Compound Interest Better for Investors?
If you want to grow your wealth quickly, compound interest is your best bet. It lets you earn on your balance, making it a must for investors. Simple interest is a great option for beginners who want to learn about investing smaller amounts. Ultimately, the right interest type depends on your personal financial goals.
Frequently Asked Questions
Are car loans simple or compound interest?
Most car loans will calculate the interest owed based on simple interest. This means you’ll only pay interest on the amount owed on the car loan.
Do banks use compound or simple interest?
Banks typically use both compound and simple interest. Oftentimes, it will depend on the individual account. To understand how interest is being calculated, it’s a good idea to read your account agreement.
Do credit cards use simple or compound interest?
Most credit card issuers will compound the interest owed on your balance. This means, if your credit card issuer accrues interest daily, this interest is added to your overall balance and interest is then calculated based on this new balance.