Understanding the difference between simple interest and compound interest is a very important concept if you are trying to create wealth. Compound interest is like travelling in a rocket while simple interest is like doing the same on a bicycle when you compare the two over time.
Let’s look at the following example.
Imagine you walk into a bank branch with ₦ 5,000 to invest. After sitting down with one of their representatives, he offers you a great deal on one of their products. This product will pay you 10% simple interest per year. This seems like a good deal and you jump at it.
After year one, your ₦ 5,000 has grown to ₦ 5,500 (10% of 5000 = 500). Year two, you earn the same ₦ 500. However, in year two, you actually had ₦ 5,500, so the percentage you earned is really less than 10%. In fact, you earned only 9% of your investment.
The reason this is the case is because simple interest does not earn interest on interest, but earns interest only on the original principal – that is your initial investment, which in this case was ₦ 5,000.
In the first year, you earned a true rate of 10%. However, in the second year, your effective interest rate reduced to about 9%. And by the end of 5 years you would have ₦ 7,500, with the effective interest rate at this time being about 6.7%!
You have ₦ 5,000 to invest and you find a product that pays you 10% interest which is compounded yearly. After year one, your return does not look much different from that of the person who is receiving simple interest as you both have ₦ 5,500. However, time is what makes compound interest so powerful, as you will see in the next years.
₦ 5000 X 10% = ₦ 500 interest. As with the simple interest, you have ₦ 5,500 at the end of the year.
₦ 5,500 X 10% = ₦ 550 interest. Now you are getting 10% on the interest you earned (10% of 500 = 50).
At the end of 5 years, your ₦ 5,000 will have grown to ₦ 8,052.55. Compounding this way, you would have received ₦ 552.55 more than the simple interest over 5 years (₦ 8,052.55 – ₦ 7,500 = ₦ 552.55) .
The more time you have, the higher the value of the interest rate, and the frequency at which the money is compounded (whether daily, weekly, monthly or yearly) are the keys to creating wealth.
This post was adapted from about.com