Lesson 1, Topic 1
In Progress

1.5. Use simple and compound interest in a variety of situations

ryanrori January 25, 2021

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Do you avoid gambling on the stock market or at a casino because you fear heavy financial losses? You may be surprised to hear that you’re just as likely to lose money because of your everyday banking decisions.

Many people collect only 1 to 3% interest on money in a savings account, while simultaneously paying rates as high as 16 to 20% on credit card balances, or retail store accounts. Over time, this can mean some pretty heavy losses.

With some Math sense and an understanding of simple and compound interest, you can manage the way your money grows (and ideally keep it from shrinking).

The principles of simple and compound interest are the same, whether you’re calculating your earnings from a savings account, or the fees you’ve accumulated on a credit card. Paying a little attention to these principles could mean big payoffs over time.

When you put money in a savings account, the bank pays you interest according to what you deposit. In effect, the bank is paying you for the privilege of “borrowing” your money. The same is true for the interest you pay on a loan you take from the bank, or the money you “borrow” from a credit card.

Interest is expressed as a rate, such as 3% or 18%. The rand amount of the interest you earn on a savings account is calculated by multiplying the money you deposit (called the principal) by the rate of interest. 

If you have R100 in an account that pays only 1% interest, you’ll only earn R1 in interest. If you shop around for an account that pays 5% interest, you’ll earn five times that amount.

In banking, interest is calculated and added at the end of a certain time period. You might have a savings account that offers a 3% interest rate annually. 

At the end of each year, the bank multiplies the principal (the amount in the account) by the interest rate of 3% to compute what you have earned in interest.

Simple vs. Compound interest

Interest is a surcharge on the repayment of debt (borrowed money). Interest is the return derived from an investment. Interest is the right to claim in a corporation such as that of an owner or creditor.

There are two basic kinds of interest: simple and compound. 

  • Simple interest is calculated once. If you lent R300 to a friend for one month and charged her 1% interest (R3) at the end of the month, you’d be dealing with simple interest. 
  • Compound interest is a little different. With compound interest, the money you earn in interest becomes part of the principal, and also starts to earn interest. 

If you lent that same friend R300 for one month, but charged her 1% each day until the end of the month, you’d be earning compound interest. 

At the end of the first day, the friend would owe you R303. At the end of the second day, the friend would owe you R306.03. 

At the end of the third day, the friend would owe you R309.09, and so on.

Compound interest is what makes credit cards and loans so difficult to pay off. The rules of interest are the same ones that increase your savings over time, only with credit and debt, they’re in the bank’s favour—not in yours. With some rates as high as 21%, collecting interest on credit card loans can be a lucrative business.

How can you be sure you’ll have enough money to live comfortably when you retire? It’s possible that you could win the lottery or inherit millions of Rands from a wealthy relative, but it’s not very likely. Most of us, however, seem to be waiting for just such an improbable event to give us financial security later in life.

There is one fairly sure-fire way to increase your nest egg. You can “rent out” the extra money you have today to go to work for you. You do this by putting it in a savings account where it will collect interest.