Investing
About Lesson

Simple interest is an interest rate calculation only on the principal amount.

Step 1. Learn the formula for simple interest:

Principal×Rate×Time=Interest

 

Step 2. Practice using the simple interest formula.

Example 1: $100 Deposit at a simple interest rate of 5% held for one year is:

$100×0.05×1=$5

 

Simple interest in this example is $5.

Example 2: $100 Deposit at a simple interest rate of 5% held for three years is:

$100×0.05×3=$15

 

Simple interest in this example is $15.

Step 3. Calculate the total future amount using this formula:

Totalfutureamount=principal+interest

 

Step 4. Put the two simple interest formulas together.

Totalfutureamount(withsimpleinterest)=Principal+(Principal×Rate×Time)

 

Step 5. Apply the simple interest formula to our three year example.

Totalfutureamount(withsimpleinterest)=$100+($100×0.05×3)=$115

 

Compound interest is an interest rate calculation on the principal plus the accumulated interest.

Step 6. To find the compound interest, we determine the difference between the future value and the present value of the principal. This is accomplished as follows:

FutureValuePrincipal×(1+interestrate)timeCompoundinterestFutureValue−PresentValue

 

Step 7. Apply this formula to our three-year scenario. Follow the calculations in Table 4.

Year 1
Amount in Bank$100
Bank Interest Rate5%
Total$105
 $100 + ($100 × 0.5)
Year 2
Amount in Bank$105
Bank Interest Rate5%
Total$110.25
 $105 + ($105 × .05)
Year 3
Amount in Bank$110.25
Bank Interest Rate5%
Total$115.75
 $110.25 + ($110.25 × .05)
Compound interest$115.75 – $100 = $15.75
Table 4.

Step 8. Note that, after three years, the total is $115.75. Therefore the total compound interest is $15.75. This is $0.75 more than was obtained with simple interest. While this may not seem like much, keep in mind that we were only working with $100 and over a relatively short time period. Compound interest can make a huge difference with larger sums of money and over longer periods of time.

Getting additional education and saving money early in life obviously will not make you rich overnight. Additional education typically means putting off earning income and living as a student for more years. Saving money often requires choices like driving an older or less expensive car, living in a smaller apartment or buying a smaller house, and making other day-to-day sacrifices. For most people, the tradeoffs for achieving substantial personal wealth will require effort, patience, and sacrifice.

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