Interest Calculator – What are simple and compound interest and how do they work on a debt?

Compound interest is an integral part of all financial transactions we make. It represents the extra cost we pay for the money we borrow, for credit card purchases made in installments, or for the interest generated from capital we have invested somewhere.

However, for those unfamiliar with the concept, interest can be confusing, especially since there are several types of calculations used when making payments or adding interest to a debt. Among these is compound interest, which can be beneficial in an investment but harmful in a debt.

That’s why we’ve gathered all the information you need to understand what compound interest is and how it works in debt, so you don’t waste more time making your financial calculations.

Keep reading to learn more about compound interest.

What is interest?

We refer to interest as the cost of borrowing money, meaning the additional rate we pay for the money we borrow from a lender. When we borrow money, the amount we must pay increases by a percentage that is used to cover the time we hold onto the money or for the lender to make a profit from the loan.

In simple terms, when you borrow money, the lender receives an additional amount due to the time the money remains with you.

For those making investments, interest is the key to making money grow. If you are investing in government bonds, for example, you receive an additional percentage as a return because the money is not in your possession.

Each lender can offer an interest rate according to their needs and as permitted by law, meaning you can find various offers in the market with higher or lower interest rates.

Among those rates is compound interest.

What is compound interest?

Compound interest is when the percentage increase occurs progressively, meaning the interest is calculated on the values used and on each installment.

In practical terms, it’s what we call interest on interest. A calculation is made based on the last installment to determine the payment and the value of the next installment, which can lead to significant growth in investments. However, in the case of debts, it’s important to be cautious because compound interest can significantly increase the amount you owe.

So, you have a debt, and interest is applied to it. The following month, you will pay interest on the amount you still owe. If it’s an investment, the interest will increase your capital. The following month, the interest will be calculated on the already increased amount, generating even more capital.

Below is an example we calculated using a compound interest calculator:

Difference between Simple and Compound Interest:

To gain a clearer understanding, let’s look at the difference between simple and compound interest and how they work in a debt. This way, when you need to borrow money, you’ll know which rate will be applied and how its calculation will work.

The main difference between simple and compound interest lies in how the interest is calculated on the debt.

With simple interest, the initial amount is taken, and interest is calculated on that amount, so you know exactly how much you’ll pay. Several loan companies use this rate when offering “fixed installment loans” to customers. This means they are calculating simple interest so you can pay installments without changes in value.

On the other hand, compound interest is based on the previous month. In other words, the interest rate is applied to the amount the debt had the previous month, which already includes interest. This is why compound interest is known as interest on interest.

For a practical example, imagine a $10,000 loan with a 1% interest rate. Let’s see how it would be calculated over a year:

• Simple interest: You have a 1% monthly rate ($100 on the $10,000), which results in a total of $11,200 after 12 months.
• Compound interest: The calculation amount increases by $100 in the first month. In the second month, the increase will already be $101. In the third month, with interest on interest, it will be $102.01. And so on. At the end of 12 months, the debt will be $11,268.25.

See how it works? You get a progressively larger increase with compound interest. This can be beneficial for an investment, where you receive more money, or harmful for a debt, where you must pay more for the borrowed amount.

What are compound interest for?

Interest serves to cover the risk of non-payment of a debt and for the lender to receive the borrowed amount back, adjusted for the time it was used. In other words, these are rates that cause the borrowed amount to grow.

In the case of compound interest, the amount grows exponentially, meaning it causes cumulative growth on the initial capital. This allows the lender to experience greater growth in their investment.

Therefore, compound interest is an extremely important tool in the financial market, as it allows for calculations that can lead to significant growth in amounts.

How does compound interest work on a debt?

Compound interest on debt works so that each month you pay a corrected amount on the outstanding balance, that is, interest on interest.

Be very careful, as your debt can increase significantly, and you may find yourself in a difficult situation where you have to pay a considerable amount.

Compound interest is often used in financial loans. Another type of loan where this rate is common is the so-called “overdraft,” which is an amount the bank lends above the funds in your checking account, repaid with compound interest. This means that if you don’t pay it the following month, interest will be calculated on the corrected amount of the debt.

Therefore, before taking on any debt, it’s important to know the type of interest being charged and to be cautious with compound interest.

What influences compound interest?

Some factors are fundamental when using a compound interest calculator. Here’s what to consider, as it will make a difference in interest when managing your debt:

Initial amount: The amount on which interest will be applied. Based on this amount, you can calculate how much you’ll pay in total with compound interest.

• Additional investment: Any additional amount added to the debt.
• Interest rate: The percentage you’ll pay as compound interest.
• Time: The term over which you plan to repay the debt.

Considering these factors, you’ll be able to calculate the compound interest on a debt and know the exact amount you’ll have to pay.

How to calculate compound interest?

If you want to calculate compound interest on a debt, keep in mind that this requires a mathematical calculation. Here’s the formula used to calculate compound interest on a debt:

M = C (1+i)t In this formula, consider the following value substitutions for the calculation:

• M: Final amount.
• C: Initial capital.
• i: Interest rate in decimal form (for example, 10% becomes 0.1).
• t: Time period in the same unit as the interest rate (preferably in months).

To make the calculation easier, we’ve created a compound interest calculator. Go back to the top of the text and run a simulation right now!

Surviving Compound Interest

Compound interest is designed to give you a better understanding of your debt’s value, and its calculation is essential to knowing exactly how much you’ll pay. Therefore, when you have a debt, you must perform all necessary calculations to ensure you’re paying the correct amount.

For this reason, pay attention to the interest rates applied when taking out any loan or debt so you’ll pay less in the long run.

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