Compound Interest: What It Is And Why You Need To Understand It

Whether you’re an investor or a borrower, you’ll want to pay careful attention to the interest rate you’re earning or paying.

Why is the interest rate so important? Other than the fact it becomes a source of income or the cost associated with you borrowing money, the calculation of interest rates occurs in different ways.

Surprisingly, the way financial institutions calculate interest has a significant impact on how much you earn or how much extra you pay a lender. The two most common interest rate concepts are simple interest and compound interest.

Let’s look at these two concepts and compare.

Simple Interest

Simple interest is the easiest way to calculate interest. Let’s say you purchase a Certificate of Deposit for $10,000 from the bank with an effective, simple interest rate of 3% per year. We’ll further assume the bank agrees to pay your interest on a quarterly basis.

When you earn simple interest, it is paid out directly to you, not added to your investment balance. With an annual rate of 3%, you would get 0.75% each quarter or dollar value of $75.

In this simple interest example, you would earn a total of $300 per year.