Any time you make use of someone else's money, such as a bank, you have to pay interest for that use — whether you're buying a house, a car, or some other item you want. The same is true when someone else is using your money.
For example, when you buy a bond or deposit money in a money market account, you're paid interest for allowing the use of your money while it's on deposit.
The financial institution that has your money will likely combine your money with that of other depositors and loan it out to other people to make more interest than it's paying you. That's why when the interest rates you have to pay on loans are low, the interest rates you can earn on savings are even lower.
Banks actually use two types of interest calculations:
Simple interest is calculated only on the principal amount of the loan.
Compound interest is calculated on the principal and on interest earned.
Simple interest
Simple interest is, maybe not surprisingly, simple to calculate. Here's the formula for calculating simple interest:
Principal x interest rate x n = interest
To show you how interest is calculated, assume someone deposited $10,000 in the bank in a money market account earning 3 percent (0.03) interest for 3 years. So, the interest earned over 3 years is $10,000 x .03 x 3 = $900.
Compound interest
Compound interest is computed on both the principal and any interest earned. You must calculate the interest each year and add it to the balance before you can calculate the next year's interest payment, which will be based on both the principal and interest earned.
Here's how you would calculate compound interest:
| Principal × interest rate | = interest for year one |
| (Principal + interest earned) × interest rate | = interest for year two |
| (Principal + interest earned) × interest rate | = interest for year three |
You repeat this calculation for all years of the deposit or loan. The one exception could be with a loan. If you pay the total interest due each month or year (depending on when your payments are due), there would be no interest to compound.
To show you how this impacts earnings, calculate the three-year deposit of $10,000 at 3 percent (0.03):
| $10,000 × .03 | = $300 — Year One interest |
| ($10,000 + 300) × .03 | = $309 — Year Two Interest |
| ($10,000 + 300 +309) × .03 | = $318.27 — Year Three Interest |
| Total Interest Earned | = $927.27 |
You can see that you'd earn an extra $27.27 during the first three years of that deposit if the interest is compounded. When working with much larger sums or higher interest rates for longer periods of time, compound interest can make a big difference in how much you earn or how much you pay on a loan.
Ideally, you want to find a savings account, certificate deposit, or other savings instrument that earns compound interest. But if you want to borrow money, look for a simple interest loan.
Also, not all accounts that earn compound interest are created equally. Watch carefully to see how frequently the interest is compounded. The preceding example shows a type of account for which interest is compounded annually. But if you can find an account where interest is compounded monthly, the interest you earn will be even higher.
Monthly compounding means that interest earned will be calculated each month and added to the principle each month before calculating the next month's interest, which results in a lot more interest than a bank that compounds interest just once a year.