It seems there is an assumption out there that everyone in the universe should understand what interest is and how it works. After counseling hundreds of folks in a mess of debt with no clue how they got there, I promise these concepts are not as widely known as every bank assumes. Today I’m going to spend some time breaking down (in simplest terms possible) the concept of interest (simple and compounding) and how/why it can work for or against you. Before you pass out from boredom, **what if I told you I could make the next ten minutes worth $55,000?** Read on and I’ll teach you what you need to know to make that true.

### What is Interest?

**For someone borrowing, interest is the cost of borrowing money.** Usually expressed as a percentage (often measured in an Annual Percentage Rate or A.P.R.), interest is the amount of money you pay over and above the amount you borrowed to have the privilege to get that money and use it for a while.

**For someone saving, interest is the reward you earn for allowing someone else to use your money.** If you put your money in a bank, it will earn money (albeit a very small amount at current rates) simply because the bank gets the privilege of using your money for a while.

### Simple vs. Compound Interest

Interest can be classified as either “simple” or “compound.” Simple interest calculates the amount of interest only looking at the **original balance** of an account. Let me explain. If you take out a $1,000 loan and agree to pay a simple interest rate of 10% per year, you will have to pay back $1,100 (10% of $1,000 is $100) if you pay it back in 1 year, $1,200 if you pay it back in 2 years, $1,300 if you take 3 years, etc. **That’s as complicated as it gets.**

**Compound Interest allows interest to build (compound) on top of interest.** Even though it is usually listed on an annual basis (APR, remember), interest can compound annually, monthly, or even daily. Using the example of that $1,000 loan with a 10% annually compounding interest rate, you’d still have to pay back $1,100 if you pay it back at the end of one year. However, if you wait until the second year, you’ll have to pay back $1,210 (because 10% interest was calculated on $1,100) and if you wait until year 3, you’ll end up paying $1,331 (10% of $1,210). Whether the interest compounds annually, monthly or daily will have an impact on the math, but let’s skip that complication for the time being.

Before you think this only applies to debt, know that the **same examples work in reverse if you’re investing money.** If you invest $1,000 at 10% simple interest, you’d pocket $1,300 at the end of year three. If you did the same at annually compounding interest, you’d end up with $1,331. Same concept, but working in your favor instead of against you.

### Amortization

Hopefully you’re not too confused at this point and hopefully you understand my examples above leave out one important piece – PAYMENTS! **Pretty much anytime a loan has periodic payments, you’re getting into the realm of amortization and amortization schedules. ** A home mortgage is a great example. When you buy a home with a mortgage, you are told you’ll have X monthly payments at $Y per month with Z% APR. For example’s sake, let’s say you take out a 15-year mortgage of $100,000 at a 5% APR (and let’s assume monthly compounding this time). This means you’ll have 180 (15 x 12) monthly payments of roughly $800. Interest is calculated based on the outstanding amount owed and applied to interest and principal appropriately. See the table below from my nerdy Excel spreadsheet to see how the first few payments will work out.

Notice that after 1 year, you’ve dished out $9,600 in payments but only paid down $4,706.89 on that loan. Shew! This is interest working AGAINST you. This is why paying extra ** toward the principal** on your mortgage can save you so much interest. Click here to download the spreadsheet I used to do these calculations if you’d like to plug in your own information. Just change anything/everything in green and the spreadsheet will do the rest.

### Why Time Makes So Much Difference

We’ve spent too much time talking about debt. Let’s talk about interest in light of MAKING some money! **Compounding interest can work very much in your favor if you’ll let it.** Here’s an example from my e-booklet, available free to all Humorous Homemaking subscribers:

Now:if you are 30 years old and save $100 a month for the next five years and then never add another penny to it after that fifth year, you’ve contributed a total of $6,000 ($100 x 60 months = 6,000) and it is worth about $7,800.I f you just leave that money alone, when you celebrate your 65^{th}birthday, that same $6,000 you contributed (worth $7,800 on your 35th birthday) is worth almost $140,000 at a 10% interest rate!!!

Later:if you wait until you are 35 and do the exact same thing ($100 per month for five years and never add anything to it thereafter), you will still have $7,800 at the end of five years when you celebrate your 40^{th}birthday. When you get to your 65th birthday, that $6,000 ($7,800) will only be worth about $85,000. This is still a great amount of money, butis waiting five years worth $55,000($140,000 – $85,000)?

**Did that help or are you more confused? If you have additional thoughts, share them!**

Shawna says

Can you explain how APY works? Is that simple interest?

Barry says

Hey Shawna, rather than go into all the details in a comment, let me point you toward an article: http://www.investopedia.com/articles/basics/04/102904.asp. Basically, APR doesn’t consider compounding interest as clearly as APY does. They’re both measuring interest paid/earned, APY just looks gives you a way to look directly at the compounding of the interest. I hope that helps!

Rachel says

I was wondering what if instead of putting an additional $500 towards your mortgage for let’s say 4 years…instead put it in savings . Then after 4 years you put that lump some on your mortgage. Would you end up with the same benefit as the compound interest…would it make a difference in your total interest or principal paid?

Barry says

If I understand your question correctly, you’re saying to put $500 per month in savings for 4 years then pull it out and pay the lump sum ($24,000 + interest earned) on your mortgage, right? If so, then it would all depend on the interest rate on your mortgage vs. what your investment earned. That being said, compounding interest is a slow process. If you earn 10% per year (average) on your investment, that’s fantastic – but usually you’re in the investment market (stocks, bonds) to earn that kind of rate so there will be dramatic rises and falls. I tell people to stay away from the market unless you can DEFINITELY stay in 5 years and preferably 10 or more. Doing that allows you to think long-term and ride out the ups and downs. If you could assume 10% would happen no matter how long or short your investment term was, then you could come out ahead with your plan since 10% is much higher than any average mortgage rate right now…but that’s a pretty big uncertainty to deal with. Once I’ve saved an amount to cover emergencies, I’m going to pay down all debts (except mortgage) before I invest more. Then I’ll try to balance investments and mortgage payments to pay off the house more quickly without losing valuable time for retirement savings. Does that make ANY sense?

Melanie says

Excellent info! Thanks so much! Life keeps getting in the way of saving, but this gives me a big kick in the pants to tighten up that grocery budget and scrape out some extra savings here and there!

Stacy says

We’re so glad you found it helpful!

Julie Parcells says

Where in the world can I find an interest rate of 10% to invest my money. Highly unlikely

Barry says

Although most folks who don’t invest say I’m crazy to claim 10% returns are out there to find most of the time, they are. I just responded to one comment asking for some details. Check out the third question on this post(http://www.stacymakescents.com/ask-barry-june-26-2011) and you’ll see we didn’t make 10% during the worst economic period in a generation, but we made a decent return. I just checked and three of the five funds I’m in right now are actually over 12% for the last 12 months while the other two are at 5.5% and 9%. Not bad at all and put them all together and 10% is there. Don’t assume you can’t earn better money than a savings account. That’s what poor people do.

faye says

Stacy,

Thanks for this and all of the other information that you provide on your blog. I am a single mom with an awesome 8 year old son and way too pets who is desperately trying to dig myself out from overwhelming debt. Please continue providing these tips and hints as people like myself really need the reality checks, inspiration, and advice

Thanks

Barry says

Thanks for the encouragement. We are glad to share the knowledge God gave us. If you have any specific questions we’re here to help.

Rachel says

Thanks for the info! Now what I want to know is how to actually make 10% interest on my savings! Any simple tips?

Barry says

When we talk about those types of returns it is a discussion in investments. Mutual funds are the safest route in my opinion. I wrote about this a couple of years ago (http://www.stacymakescents.com/ask-barry-june-26-2011) and it will outline our returns when the economy was way down. Of the five mutual funds I have right now, 3 of them are over 10% return for the past 12 months. It is always going to be an up and down game, but we’re looking long term so those bumps will smooth out and they trend should be positive. I hope that helps.

KM Logan @lessonsfromivy says

Okay I seriously must start saving.

Barry says

Everyone needs to start saving! I hope this motivated some to do it TODAY!