Simple & Compound Interest & The Rule Of 72

 

Basics

Interest is money a person or establishment receives for lending money.  You will see the term "Interest" and "Interest Rates" everywhere.  You might see advertised interest rates by a savings bank telling you how much you can earn by putting your money in the bank.  The bank may also quote an interest rate for a car loan, a house loan, or quote a rate on a bond.

When a borrower receives money, let’s say from a bank, he or she agrees to pay a certain percentage, generally calculated annually, to the lender for the use of the money.  The borrower and lender also agree on a payment schedule for the money to be returned and penalties that will occur if a borrower fails to meet the agreed payment schedule.  Here are two principal types of interest—Simple Interest and Compound interest—which I have explained below.  I’ve also included a formula, the Rule of 72, which quickly shows you how long it will take for you to double your money based on the interest you will pay when you borrow money.

 

Simple Interest

How does simple interest work?  Interest of any kind, especially when it is being paid out to you, is great, because it means that your money is working for you.  Let’s say you put $500 in a bank which gives you 5% interest.  This is an annual interest rate (APR) which most of the time is calculated daily and posted monthly.  The bank pays you for the use of your money.  If you leave that $500 in the bank for an entire year, at the end of the year you will have earned $25 ($500 (deposit) x .05 (5% interest) = $25.  Therefore, at the end of the year you now have $525 in your account without you lifting a finger.  Check out the below Website to calculate simple interest.
http://www.webmath.com/simpinterest.html

Compound Interest

What is better than simple interest?  Something called Compound Interest.  Not only will you earn money on what you have saved, but you also earn money on the interest you received on that money (if you leave it in the bank).  Let’s take that $500 you put into your bank.  If you don’t touch it for five years, your account would be worth, $634.14.  This would be compared to $625.00 if you only had simple interest, not compound interest.  Furthermore, if you continue to add money each year to your account, say $100 per year, by the end of five years your account would be worth $1,218.33.  Your money keeps growing as long as you don’t touch it.  If you want to calculate your compound interest, here is a site that provides you with a compound interest calculator:

http://www.webmath.com/compinterest

http://www.econedlink.org/interactives/interest.html

 

Investing And The Rule OF 72

If you want to quickly figure out how long it would take to double your money, use the rule of 72.

72 divided by interest rate = number of years to double your money.
  • If you receive a 6% interest rate, divide 72 by 6, which gives you 12.  This means it will take you 12 years to double your money.  The reverse: If you know you want to double your money in eight years, divide 8 into 72 to find that it will need to find a 9% interest rate to achieve that.
  • http://www.moneychimp.com/features/rule72.htm