Compound interest 101: The rate that keeps on building

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One of the reasons why we might sometimes fail to optimize our personal finances is from not having a full understanding of how certain money-related matters really work, even though you’re relatively familiar with them in day-to-day life.

Plenty of consumers pursue home loans all the time, but aren’t truly educated in the way mortgages function. You may have a primo healthcare plan, and you’re acquainted with terms like copay, deductible and coinsurance, but can you really define them if asked? (Only 4 percent of people really know.)

Then there’s interest. Most people should know that interest comes at a certain rate, and it can be paid, like on a savings account, or it can be owed, like on a loan. That’s simple enough without complicating things too much, right?

But that’s precisely the problem. Interest can be both simple or it can be compound, but do you really know the difference between the two? Learning the basics of compound interest can keep you out of debt and save you money without getting too complex.

What is simple interest?

Simply put, simple interest is a set rate applied to a principal balance. If you opened a savings account with a \$5,000 opening balance, and a 5 percent rate paid out each year, you’d be paid \$250 in interest at the end of the first 12 months.

At the start of the second year, your account would then be worth \$5,250 (barring any new deposits). At the end of year two, you’ll earn another \$250, since the simple interest rate earns money on your initial principal balance of \$5,000. Regardless of your current balance, a simple interest rate will always build on the same original rate from your starting balance.

What is compound interest?

Compound interest builds on top of your principal plus the interest you’ve earned. Like simple interest, rates can be broken down into two abbreviations: APR, or Annual Percentage Rate, interest tacked onto loans; and APY, Annual Percentage Yield, interest earned, or yielded, on a deposit or investment account. Learn more here about the differences between APY and APR.

Say you opened another savings account that compounds interest, with the same initial amounts: \$5,000 at 5 percent. Year one returns will be the same as above -- \$250 in earnings, bringing your balance to \$5,250.

But in year two, you’ll earn 5 percent on top of your total current balance -- \$5,250 -- not your opening balance of \$5,000 like you would in a simple interest setup. Now, you’ll earn \$262.50, for a total balance of \$5,512.50. After year three, your 5 percent rate will earn \$275.63, and so on. Of course, the more you deposit, the further that 5 percent APY goes to earning more dividends. (Should rates fall, the current interest rate will still compound, giving you the advantage of interest on top of interest.)

Granted, these are examples for the sake of illustration. Many deposit accounts are known to carry low interest rates that hardly seem to pay out anything. (The current savings rate as of this writing, according to the Federal Deposit Insurance Corporation, is a paltry 0.06 percent.) But with future deposits, in tandem with compound interest, you’ll get to see how much your finances will grow over time.

Compound interest and loans

Both simple and compound interest in lending work the other way around, benefiting the lender, not the borrower. A simple interest rate stays static on the original principal balance, which is why it’s not common to see in lending. Compound interest can generate more revenue for a lender, since interest at a fixed rate compounds on money you owe, and continues to build on any unpaid balances you may carry.

Take a \$20,000 loan with a simple annual interest rate of 8 percent that’s due in 48 months. Eight percent of a \$20,000 is \$1,600. With simple interest, you’ll owe that same \$1,600 on top of your principal balance each year for 48 months, so by the end of the loan, your total interest owed would be \$6,400, and your ending balance, \$26,400. Nothing has compounded since the interest owed remains the same each one-year period.

Imagine the same loan above, at \$20,000 and an 8 percent APY that compounds once a year. You won’t see a difference between compound interest and simple interest in year one, since you only have a base principal amount to work with. After one year, the loan will have accrued \$1,600 on top of \$20,000, totaling \$21,600.

But at the end of year two, the 8 percent interest rate will compound on top of that existing principal (with accrued interest), so you’ll owe \$1,728 in interest, for a total balance of \$23,328 (\$21,600 + \$1,728).

Some compound interest tips

• Time can work for or against you. The longer your interest is allowed to compound on a savings account -- for instance, on a 60-month certificate of deposit -- the more your balance will be worth over time. However, the longer a loan balance goes unpaid, the more compound interest can build. With a credit card, compound penalty interest can cause debt to grow, making it harder to pay it off, and the more money your credit card company makes.

• Compound interest can be your friend or your enemy. Simple interest isn’t used much in savings and lending, primarily because it doesn’t yield much money for savers and investors, and lenders don’t make much money off it. That’s why most loans, credit cards and other lending products utilize compound interest. Credit card minimum payments are essentially structured to keep pace with compounding interest; by paying only the minimum on your card each month, interest compounds and accrues on your remaining principal balance, making it more difficult to pay off. (Credit card companies aren’t eager to tell you this.) When it comes to deposits, always seek out compound-interest bearing savings accounts, and pay off your credit card and loan balances in full each billing cycle. This will ensure your finances grow through interest rather than being offset by it.

• Check how frequently your interest compounds. The more frequently it compounds, the bigger difference it makes in how much you earn or owe. An account principal balance that compounds interest quarterly or monthly will increase more quickly than one that accrues on an annual basis. Good if you’re saving, bad if you’re borrowing.

• Do your math. When you take out a mortgage loan, auto loan, student loan, or any type of loan, for that matter, the law -- specifically, the Truth in Lending Act -- requires that loan terms are disclosed to you, including if the interest on the account is simple or compounding. Nonetheless, do your diligence and crunch some numbers before taking out the loan to see how the math adds up. Apart from confirming that interest on your loan will compound (as opposed to a simple interest rate), you’ll see more clearly how your payments can fit into your budget.

• You can simplify the effects of compound interest. Compound interest can hurt your finances, but only if you let it. By better budgeting, finding ways to save, and cutting back on discretionary expenses, you’ll be able to free up money towards making larger loan payments. This will help pay down your debt earlier, or, at the least, to pay down your interest first before it has the chance to accrue on your principal balance. It’s a financially smart approach to handling everything from car loans to student loans, where rates, while fixed, can inflate the amount you owe beyond the value of what you’ve borrowed.