Do interest rates baffle you? Are you scratching your head over the differences between simple and compounding interest? Many members ask us these questions and more. So, we're laying out the differences and providing tips on what you need to know to make savvy money decisions.
You probably already know something about interest. After all, it's everywhere, from credit cards to car loans, personal loans, mortgages, and more. Yet did you know the two types of interest – simple and compounding – work differently in lending and affect your savings differently, too? It's true! We'll dive into how it affects you, from borrowing to saving and investing.
What is Interest?
When you think about interest, borrowing comes to mind. Interest is the cost of borrowing. You might pay a little or a lot of interest. It depends on the term of your loan, how much you borrow, and the interest rate. The annual percentage rate is the yearly interest you'll pay on your loan's principal.
Interest has another purpose, too. Savings accounts also use interest to help you grow your money. Think of interest as how your savings account works for you instead of the other way around. Instead of how much you pay, interest on savings, eLife Checking, or share certificate accounts is how much your money earns.
How Simple Interest Works
Simple interest is a flat interest calculated on the amount you borrow only. Some loans, like personal loans or auto loans, use simple interest.
If you pay $1,000 on simple interest for 12 months with a 10% APR, you'll pay $1,100 over the loan term.
$1,000 x 1.10 (10% interest) = $1,100
We love how easy simple interest works. If only all things in life were this simple, right? However, there’s another type of interest that drives your loans, credit cards, and savings accounts, and that’s compounding interest.
Compounding interest is more complex than simple interest but deserves special attention. Credit cards are an example of compounding interest.
Ever wonder why the bill for that credit card in your wallet grows if you don't pay it off monthly? Credit cards use compounding interest, which means you're paying interest on your previous interest plus your outstanding balance. However, loans like this aren't the only things that use compounding interest. You can also earn more on your savings accounts with compounding interest.
How Interest Affects Your Savings
Interest rates fluctuate with the market, so always check the current rates before you deposit your money or get a loan or credit card.
When you’re looking for loans or credit cards, you want the lowest interest rate possible since this is what extra you’ll pay on the loan or credit card.
The opposite is true when you open a deposit account such as a savings account, e-Life checking account, or a share certificate. Your goal for a deposit account is different from when you borrow money. Here, you’re aiming to grow your money as much as possible, so you want the highest interest rate you can find. Savings interest is the annual percentage yield, or APY. It’s money you earn, not what you pay.
Here’s how it works:
Let's say you deposit $5,000 into a 13-month share certificate with an interest rate of 0.85% annual percentage yield. You leave the money in the share certificate account untouched for 13 months. How much will you earn? There's an easy way to find out. Our compounding interest calculator reveals you'll gain $42.50 over the first 12 months, and you still have one month left in the term to earn more.
Conclusion
The great thing about share certificates is that they earn a much higher interest rate than standard savings accounts, which makes them a fantastic choice for growing your savings. In a way, earning interest on your savings is like receiving free money! And the more interest your account makes, the more money you gain.
With that said, you’ll want to maximize your approach for the best results. Savings accounts are an excellent choice for the money you might need easy access to in an emergency. Share certificate accounts offer a good option for money you can afford to leave untouched over a longer term.
Look for deposit accounts that offer the highest interest rate possible. You’ll often see this with share certificates since they carry a time commitment. Sometimes banks and credit unions offer special promotions on share certificates that allow you to snag a higher interest rate for a limited time. If you can, take advantage of these promotions because you’ll earn more during the promotional period.
Figuring out which savings accounts work best for you is always a tough decision. Rather than leaving it to chance, schedule an appointment with us. We'll discuss your goals and guide you to the right savings tool for you.
