If you are unsure how to calculate how much interest you will be charged when borrowing money, you are not the only one. The differences between types of interest can be confusing at times, making it difficult to determine the math you need to do to know the amount of interest you’ll pay on your loan.
You might have heard positive things about simple interest on lending products and might be wondering how can simple interest make saving money easier. No worries! We’ve got you covered.
Understanding the differences between simple interest and compound interest is an excellent first step in borrowing money responsibly. It can also help you learn how to invest wisely to get the most out of your savings account and portfolio building.
Simple Interest Vs. Compound Interest
The difference between simple interest and compound interest comes down to how the interest rate accumulates. Put plainly, a simple interest rate accumulates on the principal balance alone, while a compound interest rate accrues on both the principal balance and the accrued interest.
By breaking down how each form of interest functions, we can clarify which one might be better and in which circumstances for your finances.
Simple Interest
As suggested by its name, simple interest is relatively straightforward. Simple interest is calculated as an annual percentage rate on the principal amount only. To calculate simple interest to determine how much you will pay on a loan balance or accrue on a savings account, you must multiply the principal balance by the annual interest rate and then by the number of years you invest or borrow money.
Simple interest is often common on car loans, personal loans, and traditional mortgages. Since the interest accrued is only on the principal amount, these loans tend to be a lot more affordable than other lending products.
Meanwhile, simple interest is not that common for investments, except for bonds, which allow you to earn simple interest on the initial investment.
Compound Interest
On the other hand, compound interest is not quite as simple (pun intended). Compound interest accrues not only on the initial principal balance but also on the accumulated interest. Therefore, the amount of interest charged is calculated with a percentage rate applied to both the principal amount and whatever interest was accrued during previous periods. Compounding interest can use any time period, even daily.
You will find that compound interest is common on credit card balances, which usually compounds daily, and online payday loans and other short-term loans use a compound interest formula. Compound interest is far more costly than simple interest when you borrow money.
Adversely, compound interest helps you earn significantly more money when you deposit money in interest-bearing savings accounts, including money market accounts and certificates of deposit. Compounded interest benefits you when saving money as you earn more interest as time goes on.
Borrowing or Saving?
If you are trying to determine which one out of simple and compound interest makes saving money easier, it all comes down to whether you are borrowing or saving. Whether you make interest payments or earn interest will let you know if compound interest or simple interest is more beneficial to you.
When borrowing money, simple interest is your friend, and while saving money, compound interest is your friend. And here is why:
Simple Interest Minimizes Costs On Borrowing
Simple interest benefits the borrower as your accrued interest is not included in the balance that the loan’s percentage rate is applied to. Simple interest is calculated only using the principal amount you borrowed, so you will end up paying less interest overall than you would on a loan with compound interest.
A simple interest loan will make it easier to save money as your interest rate will stay fixed at the annual rate so that your monthly interest doesn’t increase when the balance owed rises due to previous interest.
Compound Interest Increases Return On Saving
Just because a simple interest loan helps you save a considerable amount on overall interest payments doesn’t mean that compound interest isn’t good for anything. Compound interest on a savings account is excellent for investing.
When you have compound interest on a savings account, the interest amount you earn will increase as your balance increases making it possible to save more money than you would through simple interest. Hence, compound interest is the perfect avenue for building wealth.
Calculating the Interest On Your Loan
Simple interest loans like car loans and mortgages are incredibly easy to calculate. The simple interest formula to calculate the interest you will need to pay is the principal balance of your loan multiplied by the interest rate, then multiplied again by the number of years.
Here is a simple interest example:
Let’s say you are taking out a personal installment loan of $1,500 to renovate your bathroom. The loan has an annual simple interest rate of 7% to be paid back over a period of four years.
Calculating simple interest paid is done by multiplying $1,500 by 7%, then by four years.
$1,500 X .07 X 4 = $420
Then you can calculate the total amount that will need to be repaid by adding the interest to the money borrowed.
$420 + $1,500 = $1,920
As you can see from the calculations, if you were to pay off your loan early, the total balance you will need to pay will decrease. For example, if you were to pay off your loan two years earlier than scheduled, you would be able to cut the interest charges in half.
Two years of interest instead of four:
$420 / 2 = $110
Total balance to be paid minus two years of interest:
$1,920 – $110 = $1,810
Paying Off Your Loan Early to Save Money
If you are looking to save money by paying off your simple interest loan early, here are a few tips and strategies that can help:
Make Bi-Weekly Payments
Instead of only making monthly payments on your installment loans when they are due, consider making payments more often. If you make early payments every other week, you are likely to get more paid down by the end of the month.
You may have already gone over your budget or spent all your disposable income when you wait until the end of the month to make your payment. This could have you consistently paying the minimum amount when you might be able to afford significantly more.
Round-Up On Your Monthly Payments
Always round up your monthly payments even when you can’t afford to pay more than the minimum. Rounding up your minimum payment on those months where you don’t have room in your budget to make too big of a dent in your debt will allow you to still work towards early repayment.
Simply rounding up to the nearest $50, if you can, will not break the bank, but it will add up if done consistently when you can’t manage more.
Cut Down On Expenses
Suppose you want to save the maximum amount of money by paying off your simple interest loan as early as possible. In that case, the best thing you could do is sit down and reevaluate your budget to cut down on any expenses, even temporarily.
Cancel any frivolous subscriptions. Stop eating out or ordering delivery for a few months. Do a detox on all online shopping. Whatever extra money you have from cutting down on your spending, put it towards supplementary loan payments. Doing this should make a significant difference in how long it takes you to pay off your loan, thereby making your interest payments lower.
All you need to do to use simple interest to your advantage on anything from auto loans to student loans is pay off that loan early. Depending on the size of your loan and how early you can pay it off, you could save yourself hundreds of dollars on interest.
References:
What is simple interest? A straightforward way to calculate the cost of borrowing or lending money
Simple vs. Compound Interest
5 Ways To Pay Off A Loan Early
