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Financial Literacy Lesson 4 – Compound Interest

Today we’re going to be looking at interest. Specifically, simple interest vs compound interest and how those two affect the final amount of money you’re going to get at the end of the loan.

We’re going to start off with simple interest and the formula for simple interest.

Disclaimer: You don’t have to read this post if you don’t want to. But, we’re going to geek out and use the compound interest calculators you get for FREE when you subscribe to our newsletter. Personally, I highly recommend it because you’ll learn a lot.

Simple interest

A = P(1+rt)

A = Final amount (how much you get at the end of the loan)

P = Initial Principal Balance (Amount you lent)

r = Annual Interest Rate

T = Time (how many years are you loaning for)

You are taking the amount of money you have and you’re going to loan it (P). You times that by 1 plus an interest rate (r) for a period of time (t). What you get is a final amount that tells you what your ending amount will be.

That’ll help you determine whether the investment is good and whether it’s something that satisfies you with the amount of money you put up for a specific interest rate and time period.

Let’s use an example:

P = $1,500

r = 9%

t = 50 years

Using the formula P(1+rt) we get the following:

8,250 = 1,500(1+0.09*50)

or $165 per year.

This is an investment I wouldn’t do because the return isn’t enough for 50 years. I mean, $8,250 after 50 years…?

Macintosh HD:private:var:folders:pm:tt4jdt2570q2fldqh96tvw700000gn:T:TemporaryItems:Screen Shot 2020-05-04 at 2.02.16 PM.png
Macintosh HD:private:var:folders:pm:tt4jdt2570q2fldqh96tvw700000gn:T:TemporaryItems:Screen Shot 2020-05-04 at 2.02.42 PM.png
These two screenshots of our excel compound interest rate calculator shows the amount we get each year. So notice, that by year 50, the amount is $8,250.

That’s simple interest and how to calculate simple interest.

Compound Interest Formula

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This is the compound interest equation. Everything is pretty much the same, except we have a new variable n, which is the number of times interest is applied per time period. Usually, it’s compounded monthly. Therefore, unless otherwise mentioned, just always use 12 because there’s 12 months per year.

Compounding 12 times per year means the interest is applied monthly.

Let’s reuse our last example:

P = $1,500

r = 9%

n = 12

t = 50 years

The only different is we have n being 12.

Applying that with our formula:

1,500( 1 + 0.09/12)12*50

Notice that we use 0.09 that is calculated from 9 ÷ 100.

This calculation will give us $132,777.

By the way, if they say we are compounding daily, what does that mean?

It means that n will be 365 (because there are 365 days per year) instead of 12.

Know How Compound Interest is Calculated and Your Financial Basics

Are you loving math classes yet? I promise this is as DRY as it gets, but it shouldn’t be that dry because we’re talking about using money to make you money. That should get you excited instead!

If you aren’t interested, then you aren’t interested in money. Then! By logical determination, there is something wrong with you! Hahaha!

Jokes aside, you can also just have people tell you (like a financial advisor) what’s good for you or not. But, that’s being financially irresponsible. That basically believes that someone has your best interest at heart.

Here’s the thing. You need to know your financial basics and cover your financial fundamentals. You CANNOT give money to someone expecting him or her to do the best for you. It’s NOT their money; it’s NOT their future. If your portfolio loses money, it loses money; they are NOT going to lose sleep. But, you certainly are.

However, who is to blame in the situation? The financial advisor? NO! It’s you! If you understood and are learning the financial fundamentals (like you’re doing now), you will be able to understand if the financial investment is good for you.

I have a friend who knows nothing about simple interest vs compound interest. Their way of “being responsible” is saying, “I have a financial advisor that does that all for me”, which is the most irresponsible statement ever. They know nothing about money and are putting blind faith in an advisor they don’t really talk to. That is INCREDIBLY RISKY and my suggestions of learning a little bit more about money are unheeded.

Which leads me to another thing, talk to your financial advisor. I do it ALL the time. Pretty much on a bi-weekly basis. For one thing, I learn a lot about the economy, macro and micro-economics, commodities, and things that I NEVER FOUND interesting, but when I learned a little bit more I was like “Wow! That’s what’s happening? It sounds like a conspiracy, but it makes sense!”

You can do that too. You can learn all this. Just subscribe to our newsletter.

Which Do You Choose Compound Interest vs Simple Interest?

Of course, you’re going to pick the compound interest formula or else you could donate money to me because we know who’ll take better care of that money.

The Time Value of Money

The money you have now is MORE VALUABLE than the same amount in the future. Why?

Because of its ability to EARN INTEREST.

Any time you have money in your account, ask yourself what the interest rate is. If it’s in a checkings or savings account, it’s nothing. Put your money somewhere else.

Right now, if your money is in your checking or savings account, give it five years, it’ll still be the same (or a minuscule amount more). I’ll tell you why in a later lesson. But checking and savings is the worst place to put your money, get it out NOW!

Conclusion

That’s it for today, I know you learned something and it wasn’t that bad was it?

In fact, today’s post was shorter than all the others. So, we saved you some time and you got good value out of it. Again, be sure to sign up for our newsletter.

Financial Literacy Lesson 4 – Compound Interest VIDEO

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