Importance of Interest Rates and Compounding

To follow up with my previous article about choosing the best online savings bank, I want to explain the importance of Interest Rates. An interest rate is defined as the following in Investopedia:

The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the “lease rate”. (link)

This is the main way banks make their money because they lend it out to the consumer and we pay back what we borrow plus interest (which is basically the agreed upon cost that you pay the bank for lending you the money). Well, banks charge a sizable amount of interest for the loans that they make to consumers, they rarely return the favor when borrowing your money.

This is evident by the sub par 0.1% interest that some banks pay you yearly to borrow your money. For more information about how banks work review the video below:

Money As Debt



Well, as the consumer, it is time for you to get in on some of the action. After all, as hard as you work for your money, you should get the same benefits of receiving some type of return on the money that you are lending out. This is where the importance of the interest rate that you are receiving comes in because this rate determines how much money your investment/savings will bring you back in a year.

For a quick way to calculate how long it will take your money to double at a certain interest rate, review my previous article about the Rule of 72.

The interest rate alone is not the only factor that contributes to the return your money will bring you. There is another factor called "Compounding" that is defined as the following by Investopedia:

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings. (Link)

Compounding combined with a solid interest rate is a recipe for success. This allows you to fast track your savings (when starting early) because the money that you make from interest is then re-added into your principal amount, resulting in making more money from interest on that particular amount. This is much better than the alternative, simple interest, as that only pays interest on the principal alone. Below is a an example to comparison between compounding and simple interest:

You have $100 invested in two different banks. One bank offers simple interest while the other bank offers compounding interest. You are going to leave the money invested in the bank for a period of 50 years and the bank has guaranteed that they will pay you 10% interest for your money each year.

Simple Interest

Principal Balance: $100

Interest Rate: 10%

Value after one year: $100 + (100 * .10) = $110

Value after five years: $100 + (100 * .10) * 5 (no. of years) = $150

Value after ten years: $100 + (100 * .10) * 10 (no. of years) = $200

Value after twenty years: $100 + (100 * .10) * 20 (no. of years) = $300

Value after fifty years: $100 + (100 * .10) * 50 (no. of years) = $600

Formula to calculate:

Future Value = Principal + (Principal * Interest * no. of years)

Compounding Interest

Principal Balance: $100

Interest Rate: 10%

Value after one year = $110

Value after five years = $161

Value after ten years: = $259

Value after twenty years = $672

Value after fifty years = $11739

Formula to calculate:

Future Value = (Present Value) * (1 + interest rate)^{number of years remaining}

I am hoping that the information in this article has helped to convince you to understand the importance of interest rates and the significance of compounding interest versus simple interest. As usual, if you have any questions or comments, leave them in the comments section below.

Stay Disciplined!