Friday, June 24, 2016

Simple vs Compound Interest Part 2

Dollar, Piggy Bank, Financial Crisis  Yesterday, we looked at what types of loans used simple interest but when is compound interest used? A few things I looked at yesterday that I thought were compound interest turned out to be simple interest.

Compound interest is considered as profit growth, growth being the key word.   So this type of interest is applied to accounts you want to grow such as for retirement.  Depending on how much you invest and how long its invested, it will determine how much you accrue in your fund.

Money under 30 has a wonderful diagram and explanation of what saving a bit of money for a 10 year period at ages 25, 35, and 45 and letting it grow till retirement.  It is very clear and absolutely great.  I know from personal experience that at first it seems like your funds are not growing but after a few years, everything starts growing and it just becomes a larger amount than expected.

Another item that uses compound interest is your credit card.  If you only pay the minimum payment, it takes a very long time to pay it off and you pay way more interest than you might otherwise.  Business insider has some wonderful examples that demonstrate this using real life scenarios.   Credit cards break the per year rate down to a daily rate and recalculate the amount of interest based on this and an average balance. 

Basically if you are charged APR or or annual percentage rate it indicates they using simple interest but if its APY or Annual percentage yield, it indicates they are using compound interest.  In general if you are borrowing a set amount for a specific time period, its going to be simple interest or a variation of it.  If you are setting up something with a varying and ongoing amount like your credit card, its going use compound interest.

So the next time I teach these formulas, I can give students more information on when these sorts of interest are used.  I realize there are exceptions and variations but for students who don't know much about borrowing money, this is a good start.