Understanding Compound Interest

Albert Einstein has been quoted as saying “compound interest is the eighth wonder of the world. Those who understand it, earn it, and those who don’t, pay it.” In investments and loans, there is often going to be interest. It is the price you pay, or get paid, when money is loaned. The interest can be expressed as either simple or compound interest. Understanding these principles allows one to truly understand the cost of their purchase or the potential return of their investment. Compound interest has a way of escalating exponentially. This can drastically impact the final amount being paid by the debtor. Let’s take a look at both simple and compound interest.

What is Simple Interest?

Simple interest is expressed as shown in the formula below. 

SI= P x R x T

Where P=Principal, R=Rate of interest, T=Time

You are paying interest based off of the rate of the loan, the amount of loan remaining and the time parameters associated with that loan.

What is Compound Interest?

Compound interest is a little bit more involved to calculate because you are not only paying interest on the loan amount, but ALSO any interest that has accrued. If your interest in your loan is compounded daily, then you are paying interest everyday on an ever increasing amount of money. 

Why Is This Significant?

With compounding interest, there is a snowball effect that happens with investing. You reach a certain point where your money begins to work harder for you and the interest outweighs the principal contributions. 

The graph above depicts a scenario where there is an initial investment of $1,000 and is earning interest at 10% for 20 years. At the end of 20 years, the person getting simple interest will have a total of $3,000 whereas the person with compounding interest would have $7,000. You can run this scenario for different initial investments, rates of return and term lengths, but the compound interest rate will always be greater than the simple interest scenario. This is not only important when investing, but also paying back loans. The longer you let loans with compounding interest stick around, the more interest you pay. If you are in a situation where your monthly payments are not even covering your interest rate, you will have a loan balance that rises despite making regular payments on it. 

Many factors go into determining whether an investment is appropriate to pursue or whether you feel comfortable taking on a loan with various terms attached to it. Being well informed about your decisions and their consequences is paramount.

-Dr. Zach Baker, PT, DPT, SCS . Do you want to chat further? Engage and discuss with Zach on Instagram HERE!

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