Cash Course: Simple vs. Compound Interest

whoa is that a Prager station five yeah I camped out all month for it wow doesn't that cost like 350 dollars how did you pay for it oh easy I just use a credit card ah well I hope you paid off soon or you'll owe a bit more than 350 dollars why is that well there's a thing called interest usually a certain percentage charged by lenders when you borrow money including credit card lenders interest covers any risk associated with the loan but interest can also be earned from saving and investing interest mainly comes in two forms simple and compound simple interest is only calculated on the principal the original amount invested or borrowed compound interest on the other hand is when the interest is added back to the principal increasing it and then the next round of interest is calculated based on that higher principle say that again but slower all right let's break it down take for example a bank that offers you an annual simple interest rate of six percent on a savings account you deposit a thousand dollars and then come back a year later you now have one thousand sixty dollars in your account pretty sweet the extra sixty dollars is the simple interest you earned over the year and the principal has remained the same now take one thousand dollars to a bank which offers compound interest in same interest rate of six percent but this time it compounds monthly the bank spreads the six percent interest rate over 12 months and then uses it to calculate the amount of interest earned each month the interest is then added back to the principal increasing the principal amount this process repeats every month as you can see the principal grows you earn interest on your interest after a year you would have one thousand sixty one dollars and sixty nine cents in your account a dollar sixty nine may not seem like a lot but over a longer period of time and with additional deposits it could be a huge difference really how use the rule of 72 which only applies to compound interest accounts take 72 and divide it by your interest rate and you get the number of years it'll take to double your money in our six percent interest example you would double your thousand dollars in 12 years on the other hand it would take nearly 17 years to double it in a simple interest account that's a difference of five years yes yes it is anyway when it comes to investing compound interest is better than simple interest you can't be earning interest on your interest so what kind of inches is best when eyebrow money well when borrowing simple interest is usually best since interest is only charged on the principal balance most often the balance is paid off in monthly installments say you borrowed 25 000 to buy a car the annual percentage rate APR on the loan is five percent and you plan to take five years to pay it all back your monthly payment is 471.78 each time you make your monthly payment part of the payment goes toward the amount of interest that has accrued over the month and the rest goes toward the principal balance as the principal reduces a little less of your payment will go towards interest and a bit more will go toward your principal balance what about my pragerstation 5 purchase well since you used a credit card you could be paying interest on interest interest compounds daily on any balance remaining past the payment due date let's take your 350 dollars chest and use a typical credit card APR of twenty percent that makes your daily interest rate point zero five five percent or 19 cents for every day that the balance rolls over past the due date the next day you would be charged interest on the new principal of three hundred fifty dollars and 19 cents this process would continue until the balance is paid off in just one month you could owe up to an additional 5.82 this may not sound like much but it adds up quickly now that you know how interest works you can prepare for it in your own finances there are plenty of online calculators to help you figure out exactly how much you'll be paying or earning once interest is applied to your principal shop around for the best rates remember you want low simple interest rates when borrowing and high compounding interest rates when investing after that it's all about time the faster you pay off a loan or credit card the less interest you end up paying and the longer you save or invest the more your earned interest builds up interest is going to be part of your financial Journey so be smart about it soon enough you'll be a pro when borrowing and investing and you'll be making the most out of your money thanks maybe I can still return this watch more at prageryoukids.com and parents don't forget to subscribe