To jump start our journey to financial literacy we need to establish an understanding of the basic terms that are frequently use. This is will be an on-going series called “The Financial Essentials”.
Lets start Simply… with Simple Interest
Simple Interest – is a relatively “simple” formula that allows you to calculate how much interest applies to a principle balance, such as a car loan or a savings account. It is a good way to estimate how much interest is paid or earned on a particular balance in a given period of time. The formula is as follows:
Simple Interest = Interest Rate X Principal Balance
Please note though simple interest does not take into consideration the effects of compounding interest, which will be covered in a follow on post.
Being able to calculate simple interest transfers quickly into real life. You opened that savings account down at the local bank or a CD account at an online-only bank. Maybe you opened a new credit card or took the plunge on a new car. Being able to calculate simple interest gives you a quick back of the napkin estimate of how much extra your cash is earning or how much extra your payment or loan is going to cost. It also allows you to compare the earning potential between multiple investment options quickly.
For example your local bank may be advertising a savings account as yielding a 1% annual percentage rate (APR) or interest rate. You have $1000 you would like to put away to start an emergency fund, how much simple interest would your $1000 earn in one year, with no compounding effects?
(0.01)(Interest Rate) X $1000 (Principle)= $10 (Simple Interest)
But your bank is also offering a Certificate of Deposit (CD) with a yield of 2.5% with a 1 year maturity term. Using your $1000 from before…
(0.025)(Interest Rate) X $1000 (Principle) = $25 (Simple Interest)
Quickly you are able to measure the income potential for your money. Each of the above two options do have their own circumstances that impact the interest rates offered though. Both a savings account and certificate of deposit are very safe methods of storing your money, but the accessibility to that money is where these options defer. A savings account can be accessed daily, where as a CD usually has long maturity dates that limit access to your money until after the maturity date. This difference in accessibility impacts the rate of return your money earns. We will go into additional detail on savings accounts vs CD’s in future “Financial Essentials” posts!
Our next Financial Essentials will cover the magic of “Compounding Interest”
Disclaimer: I am not a financial adviser. These blogs are for educational purposes only. Investing of any kind involves risk. While it is possible to minimize risk, your investments are solely your responsibility. It is imperative that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments.
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Categories: Financial Essentials