Simple or Compound Interest.

Its funny but when we teach math, we teach both forms of interest, simple and complex, but we don't usually take time to explain which is used more often and with what.

The actual definition of simple interest is the interest calculated on the principal while compound interest calculates interest on the interest.

For the borrower, simple interest is better because it means you pay less money overall while you'd prefer compound interest if you invested your money so you'd get more back.

There are at least four places in real life that charge simple interest when you borrow money from them. The first involves a car loans.  Most people borrow money when they need to purchase a new car so when they borrow it, its usually a simple interest loan. For a car loan, the company loaning the money, calculates the total amount of interest on the loan as simple interest but arranges payment so most of the interest is paid over the first part of the loan before the principal is paid off.

Another situation is when you get obtain a loan from a department store to buy some appliance such as a refrigerator, you are given one year to pay it off at a specific interest rate while paying equal monthly payments.  On the other hand, if you invest money in a Certificate of Deposit, the interest you earn is calculated using simple interest and set for a specific period of time so you cannot withdraw the money before the time is up without paying a penalty.  In addition, most mortgage loans are also simple interest unless they involves negative amortization.

On the other hand, most credit cards calculate interest using  the compound formula because the amount owed varies, consequently, they prefer to compound interest daily due to the changing balances.  In addition, the stated minimum payment is set so a person will never pay the money off without paying a lot of interest.

For investing, if you can arrange to reinvest any and all interest earned on money, you can create something resembling compound interest because each time its calculated, the amount of money its calculated increases because of the interest added to the principal.  In this situation, you are truly earning interest on the interest and compounding the interest.  This is considered one of the best ways to increase your money.  This is also great for investing into a retirement account.  At the beginning it doesn't seem like much but after a few years, it begins to increase much faster.

Another use of compound interest is in business when a company takes the profits and reinvests them rather than distributing them to create larger dividends in the future because the interest is being earned on the interest that was added back in.

So there you have it.  Where simple interest is used and places compound interest is used.  Let me know what you think, I'd love to hear.  Have a great day.