Simple vs. Compound Interest | Cash Course | PragerU Kids

Before we start this episode, here's a quick preview of what's coming. Ready to take charge of your finances and master the art of money management? Cash Course is your ultimate guide to financial literacy, from personal budgeting to macroeconomics. Check out more episodes at PragerU.com. Whoa, is that a Prager Station 5? Yeah, I camped out all month for it. Wow, doesn't that cost like $350? How did you pay for it? Oh, easy. I just use a credit card. Ah, well, I hope you pay it off soon or you'll owe a bit more than $350. 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 principal. 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 6% on a savings account. You deposit $1,000 and then come back a year later. You now have $1,060 in your account. Pretty sweet. The extra $60 is the simple interest you earned over the year, and the principal has remained the same. Now take $1,000 to a bank which offers compound interest. It has the same interest rate of 6%, but this time it compounds monthly. The bank spreads the 6% 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 $1,061.69 in your account. $1.69 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 6% interest example, you would double your $1,000 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 beat earning interest on your interest. So what kind of interest is best when I borrow 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 borrow $25,000 to buy a car. The annual percentage rate, APR, on the loan is 5%, 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 Prager Station 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 purchase and use a typical credit card APR of 20%. That makes your daily interest rate 0.055%, 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 $350.19. 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 in borrowing and investing, and you'll be making the most out of your money. Thanks. Maybe I can still return this. Watch more at PragerUKids.com. And parents, don't forget to subscribe.