Thursday, June 23, 2016

Simple vs Compound Interest Part 1.

At various points during the school year, we teach the formulas for interest, both simple and compound but do we take time to expose students to real life uses of both?  Let's face it, most people receive all sorts of credit card offers. There are advertisements on television to borrow money for cars, borrow against the home equity for their hearts desire, even ads for so many months before interest kicks in.

Most people do not know when simple interest or compound interest is calculated.  I usually assume its compound but after a bit of research, simple interest is used in certain cases.

According to Investopedia - compound interest works better for the investor but simple interest  is better if you are the borrower.  For instance, simple interest is usually used for Certificate's of Deposit of one year or less because interest is usually per year on these. I can tell you that Certificate's of Deposit are running below 1% right now on this type of investment.

The majority of car loans are calculated using simple interest.  Its easy to determine how much interest you will pay at the end of the 5 to 7 year period.  Although it is a simple interest calculation, the amount of money paid against the principal is less because the payment is set up to pay more interest at the beginning.  By the end of the loan, more money is paid against the principal.  One major factor of how much interest paid on the loan is determined by the length.  The longer you borrow the money, the more interest you are going to owe.  The shorter time means you pay more per month but the total interest paid is going to be less.

I don't think my students realize this.  I am not sure how many students are fully aware of this.  In my neck of the woods, use snow machines or ATVs are a much better example because people don't usually buy cars out there.  It appears most personal loans are also based on simple interest calculations.

Once you get to home loans, things get a bit more complex but are still considered simple interest but the complexity arises in the fact that you the principal payment varies.  This is another one where the interest amount paid is more at the beginning and the principal paid is more at the end of the loan period.

It appears that most loans want the majority of interest paid off first and the principal second.  This seems to be common for most loans when buying things but when do we use compound interest?  Check tomorrow for the answer to that.