We have all have heard of or know too well about interest on a credit card or car loan, which simply is the cost of borrowing money from a bank or lender and is typically expressed as a rate. On the other side of that coin, when financial institutions borrow money from you (savings account), they pay you interest. The majority of these financial institutions typically pay interest on deposit accounts- such as savings accounts, checking accounts, and money market accounts- in exchange for the ability to use your money until you request it.
There are basically two types of interest- simple and compound interest.
Understanding what these two means is the primary foundation of mastering your finances. Simple interest involves simple maths while compound interest is much more complicated.
It is important that you get familiar with these two concepts especially compound interest because the moment you start understanding how your interest works, then you become empowered to make better financial decisions that will help you save more.
Before we define what each of these means, it is important you understand what interest means. It is the fee that is paid on an amount of money, whether loaned, borrowed, or invested. Unlike compound interest, simple interest does not compound.
Compounding simply means repeating the process of earning or paying interest and adding that interest to the principal balance and actually adding more interest in the next period as a result of that increased account balance.
What Is Simple Interest
Simple interest is the fee that you actually pay on a loan or the income that you earn on your deposit. When you have invested your money in some interest-bearing accounts such as a savings account, interest is paid to you because you are lending your money to the bank to lend to others.
When lending your cash, you set the rate and earn the interest on your money over time. On the other hand, when borrowing money, you have to repay the amount (principal) plus extra payments for the interest which represents the cost of borrowing.
Simple interest is calculated using the formula;
For the purpose of this article, I will be focusing on Compound interest. A compound interest saving account can help you grow your money over time, whether you are working with a large or small balance. Compounding your balance means that you are earning interest on both principal- which is the actual amount that you have saved- and the interest that you have already accrued over the period you have saved.
How fast your money will grow will depend on the interest rate, the balance, and how often your financial institution pays interest. Depending on the institution and the account interest can compound daily, monthly, quarterly, or annually. The amount of interest you earn each year is based on the total amount of interest earned and how often interest is compounded and is expressed as the annual percentage yield or APY.
What Factors Will Affect How Much Interest You Earn
There are several factors that will affect how much interest you compound per period. Some of the factors are;
The Actual Amount of Money That’s in Your Account
The more money you have in your account, the more interest that you will earn overtime. The more there are recurring deposits, the more interest you will earn. When you withdraw your cash, the lesser the interest you earn. This means that having more money and keeping it there will eventually pay.
Interest rates are subject to the fiscal policies of the nation. For instance, the APY will change from time to time, especially when the FED raises or lowers the federal funds rate, thus be sure to be very keen to follow up on any changes in the rates.
How quickly your financial institution compounds your interest will also affect your earning potential.
Fees Charged to your Account
This is one factor that most people overlook. While the fees charged on your account will not affect the interest that you earn, they could offset your earnings. In some cases, it is possible that you may be paying more fees than the interest. It has happened before. This however will entirely depend on the institution, but most banks offer consumers a good workaround to help them avoid monthly fees.
In conclusion, whatever your savings goal is, a savings account with a compound interest would be an ideal place to stash your money. In so many ways, the interest is in your favor, and accessing your money is so easy.