Like most financial concepts, interest can be confusing. Chances are, you didn’t cover it in high school and now you’re left wondering exactly how interest works. It really isn’t all that difficult—read below to gain a better understanding.
Interest is simply the cost of borrowing money, and can be classified into simple or compound interest. Simple interest is calculated only on the principal amount, while compound interest is calculated on the principal amount as well as accumulated interest (interest on interest). Compounding can be a great way to easily accumulate wealth.
Understanding how to calculate both can assist you in making better financial decisions going forward, be they loan or investment related. Jason Hartman is a big fan of making passive income, and with a little information about interest, you’ll be well on your way.
To calculate simple interest, follow this simple formula:
Simple interest=principal x interest rate x term of the loan
So, if a $10,000 loan is taken out for three years at 5% interest, your calculation would be 10,000 x .05 x 3= $1,500.
To calculate compound interest, follow this easy equation:
Compound interest=total amount of principal and future value of interest – principal amount at present (present value)
So, using the same terms of the loan above, your calculation would be $10,000 [(1 + 0.05)3] – 1 = $10,000 [1.157625 – 1] = $1,576.25.
It is important to note that, because interest is constantly accumulating, it is not the same for all three years. The number of periods in which interest is compounded makes a big difference, with the higher number of periods resulting in a higher amount of compound interest.
Why You Need It
Interest is used to figure out your returns over periods of time for various investments, and will be necessary for evaluating their success. You may also use interest to assess the success of your money or portfolio manager, noting if they’ve exceeded the rate of return of the market over a period of time. You can calculate growth rate and better assess things like retirement savings (or any savings).
Interest can also be a very persuasive argument for investing early in life—run through a few practice scenarios in which you invest various amounts of money at various interest rates for various amounts of time. You’ll quickly see how fast the money adds up. (photo credit: Dennis Wong via photopin cc)