Understanding the difference between simple interest and compound interest is a very important concept if you are trying to create wealth. Compound interest is like a rocket ship and simple interest is akin to roller blades when you compare the two over time.
Let’s look at the following example.
You walk into your local bank branch of Dewie Cheatem & Howe with $5,000 to invest. After sitting down with one of their representatives, he offers you a great deal on one of their products. This product will pay you 10% simple interest per year. This seems like a good deal and you jump at it. After year one, your $5,000 has grown to $5,500. Not too bad. Year two you earn the same $500. However, year two, you actually had $5,500, so the percentage you earned is really less than 10%. Simple interest does not earn interest on interest, but earns interest only on the original principal. Look at the following.
$5000 X 10% = $500 Interest. You now have $5,500
Since you are earning simple interest, you are only earning interest on your original principal which is $5,000, even though you have $5,500. So the interest is still $500.
The first year you earned a true rate of 10%. However, the second year, your effective interest rate is about 9%. At the end of 5 years you would have $7,500.
You have $5,000 to invest and you find a product that pays you 10% interest which is compounded yearly. After year one, your return does not look much different than the person who is receiving simple interest as you both have $5,500. However, time is what makes compound interest so powerful, as you will see in the next years.
$5000 X 10% = $500 interest. As with the simple interest, you have $5,500 at the end of the year.
$5,500 X 10% =$550 interest. Now you are getting 10% on the interest you earned. At the end of 5 years, your $5,000 will have grown to $8,052.55. Compounding this way you will have received $552.55 more over 5 years.
The more time you have and the frequency in which money is compounded is one of the keys to creating wealth.