Financial Foundations: Decoding simple and compound interest.

Members often ask, “What is simple interest?” or “What is the difference between simple and compound interest?” Ask that question to an accountant – or a banker – and what often follows are examples of math formulas that most of us will struggle to figure out correctly when left to our own devices – especially when the device is the calculator on our smartphones.

We will dutifully share those formulas with you in a moment, but what you really need to understand about simple and compound interest is that when you borrow money you want a loan with simple interest, and when you invest money into a savings account or a certificate you want to earn compound interest. Reverse them, and your loan is going to cost you more and your savings won’t yield as much. Most financial institutions won’t offer you a loan with compound interest, but that doesn’t mean you shouldn’t confirm that before accepting the terms. The same holds true for deposit accounts. Always do your due diligence to make sure your money is working for you the best it can, either saving you money or earning more of it for you.

Simple interest is calculated on the original amount of the principal (borrowed or invested). The formula for calculating simple interest is P x r x t, where P represents the principal amount (the initial sum of money), r represents the interest rate per period (usually expressed as a percentage), and t represents the length of time the money is borrowed or invested in years.

Simple-Interest Loans

As mentioned above, loans with simple interest are the way to go. Keep the following tips in mind to ensure you’re in good standing throughout the loan term.

• The interest amount due accrues daily and changes from payment to payment. It is recommended to make payments in full, and on time to ensure the loan is paid off with in the term as defined by your loan agreement. Your loan payments are calculated and structured to be paid on time in accordance with your loan agreement. Making payments on time regulates the amount of interest and principal paid.
• You will notice that at the beginning of the repayment schedule, your payment will largely go towards interest, but as the outstanding principal goes down you will notice the interest goes down as well and more of your payment will go towards principal, thereby accelerating your payoff efforts.
• Increased monthly payments and principal-only payments reduce the outstanding principal balance and lowers the daily interest calculation from payment to payment.
• Missed loan payments, moving your due date, and loan extensions can add additional interest to your loan. Past due payments can add both additional interest and fees.

And at Lafayette Federal, we do not tack on any pre-payment penalties for early payoffs – a huge perk if you want to finish your loan repayments ahead of schedule.

Compound interest calculates the amount based on the principal and the accrued amount of interest during the term. The formula for compound interest is A = P* (1+r/n)^ (nt), where P is the principal balance, r is the interest rate (as a decimal), n represents the number of times interest is compounded per year and t represents the number of years. Thankfully, there are many online calculators that can help you determine precise returns by entering the amount of principal, the interest rate, and the terms.

In short, compound interest returns interest on top of the interest your principal has already earned, which is commonly called the “yield,” and expressed as APY (Annual Percentage Yield). With compound interest, the yield rate is higher than the interest rate, or the APR (or Annual Interest Rate) because the interest compounds.

Compound interest benefits you when you’re saving money, especially long term, because it creates exponential growth of your capital. It is not so great when you’re borrowing money, because your debt continues to snowball until you pay it off. Understanding the difference is crucial to your financial goals.