Tuesday, August 27, 2013

Choosing Between Simple Interest and Compound Interest

Interest Rates
Interest Rates (Photo credit: 401(K) 2013)
As with everything, there are perks and consequences for every choice we make. Choosing between simple interest and compound interest has certain advantages over each other depending on your needs.

Compound interest is when an interest paid on your investment is added to your total sum and the interest is calculated onto the full amount. The interest will be added to the complete total allowing the sum to increase each time. Your returns are quickly obvious with compound interest instead of simple interest. Simple interest is where the same amount of interest will be paid on the total at the same time each year.

The best way to explain the differences between the two is to create a simple scenario.

Two people are each given $10,000 by a close friend. Person A decides that putting his money in an investment would earn him the most at a 5% rate. Person B decides that he wants a faster return but less profit. So he draws on the interest as it is paid. Person B is under the illusion that he's doing well because he has managed to pocket 5.5% on his investment. This means he's making $550 every year.

Because Person A has decided that they don't want to use the return he gets on his funds from his investment, he's experiencing what most would call compound interest. Persona A is receiving his income from his investment and experiencing simple interest.

After ten years of watching his investment grow, Person A returns. The $10,000 he initially invested has quickly expanded to a whopping $16,289. Person B was only able to receive $5,500 in interest, which was spent. He's now back to his original $10,000 investment.

Person B was able to use his money whenever he wanted throughout the years but its highly unlikely that he used the money he earned for anything useful. Person A was careful to manage his money and as a result, he earned more than Person B.
Compound interest may seem like the way to go, but you should be aware that the bank or credit card company you choose to associate with will also earn a large sum of money too. It generates more profit for your bank and you also end up paying more than you normally would on your debts.

When simple interest and compound interest are compared side by side, it's obvious that compound interest is the best of the two. However, compound interest may not be for everyone. Compound interest usually works out better for people who don't have a problem with not being able to touch their hard earned money for large periods of time. For some, this may not work out. Simple interest may be better and easier on the sort of people who like to spend their money as soon as they get it. Sites such as
www.myloanadvisor.com have tools that can help you make these decisions.

1 comment:

  1. Well, I think given a choice and with the right temperament and discipline, going with compound interest seems like a far better option. In the long run you can out better off as long as inflation doesn't eat into your accumulated earnings. Am sure one can take steps to mitigate that.
    Additionally, when you think about it, a lot of wealth building is predicated on the compound interest concept. Invest now and that money will "keep working" for you for a very long time.


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