Interest Rates Explained
In the world of finance, the majority of products and instruments are calculated by interest and percentage. These vary from microeconomics — debts, investments, savings accounts to macroeconomic measurements — inflation, deflation, and unemployment rate. I know these could feel like basic concepts, however, the idea is fundamental to your financial success.
Interest is the cost of using another person’s money. When you borrow money (loan or mortgage), you pay interest. When you lend money (depositing money in a savings account), you earn interest. The amount of interest to be paid or collected is usually stated in year-long periods known as an “annual rate.” The amount of interest involved in any financial transaction is based on three elements:
- Principle: The original amount borrowed or invested.
- Interest Rate: A percentage of the principal in a specific period.
- Time: The number of periods that the principal is borrowed or invested.
There are two different types of interest — simple and compound interest. Simple interest is simply the calculation of the principal amount multiplied by the interest rate. On the other end, you have compound interest — the key to growing wealth. Compound interest in definition is an exponential function, meaning that new interest is computed by both the initial principle and the interest previously earned. Think of interest as a snowball rolling down a mountain. It may start small at the beginning, but will increase at a growing pace as more time passes. For example, Daniel initially deposits $1,000 in an investment account at an interest rate of 5% annually and grows it for 5 years with a total return on investment of $1,276.28 — compound interest compared to $1,250 — simple interest. It is important for you to start developing your compound interest early and contributing to it frequently. Now, using the same example except Daniel adds an additional $200 from his paycheck every month; his total would be increased exponentially. Referencing the chart below, contributing monthly to your investment can increase your return by an additional $1562.75, compared to letting the interest accumulate in the same time period. You just need to invest a portion of your income consistently and you will be way ahead of everyone else!
