The ins and outs of compound interest
Borrowing and saving might seem like opposites, but when it comes to interest, they’re two sides of the same coin.
Money represents potential. Used strategically, it can help you execute your business strategy and realize your goals.
Whether you’re taking out a loan or investing surplus cash, putting your money to work means dealing with interest. It can be especially helpful to understand compound interest, which grows exponentially over time. When you’re saving money, compound interest can help you earn more, faster. But when you take out a loan with compound interest, you’ll owe more money over time. Make your money do more for you by learning how compound interest can affect your bottom line.
Simple vs. compound interest
Before we get into the details of compound interest, let’s take a step back to look at interest more broadly. In general, there are two types of interest: simple and compound. The following examples define both types and illustrate the difference.
Simple interest
Simple interest is calculated annually as a percentage of the money you borrow or deposit. For example, a $100 loan with a 5% simple interest rate accrues $5 in interest in the first year if the balance remains unchanged. Similarly, a $100 deposit with 5% interest would earn $5.
Compound interest
Compound interest is much more complex. It’s calculated on the principal plus any interest that’s already accumulated from previous periods. Depending on your terms, interest can compound daily, weekly or quarterly. Every time it compounds, the principal is recalculated.
For example, if you deposit $100 into a savings account with a 5% compound annual interest rate, you’ll earn $5 the first time your interest compounds, bringing your total balance to $105 at the end of the year. The next year, you’ll earn 5% on $105, or $5.25. That brings your total to $110.25. Your balance is growing without any additional deposits.
Which type of interest is better?
Whether you prefer simple or compound interest will depend on context. Compound interest is great for saving money because it helps you earn more money faster. Simply by keeping your money in a savings account, it will grow. Special bank accounts called high-yield savings accounts offer some of the best rates for growing your wealth (more on that below).
When you take out a loan, simple interest is often less expensive, but it might not be an option. Loans with compounding interest require you to be strategic. If you fall behind on payments, the amount you owe can begin to snowball with every compounding period. However, if you get ahead on payments, you can end up owing less overall interest.
Your lender is required to disclose the type of interest they’ll charge and the total dollar amount of interest that will accrue over the life of the loan. As long as your payments stay on track, you shouldn’t have any big surprises.
How to measure interest: APY vs. APR
Two of the most common ways to express interest rates are APY and APR. They sound similar but are actually opposites.
APY stands for annual percentage yield. It’s how banks express how much interest you’ll earn on your deposits. Importantly, APY reflects compounding interest, so if you see a high APY advertised for a savings account, you’ll know your interest will be higher than with a lower APY.
APR stands for annual percentage rate. It reflects the cost of borrowing money using simple interest. It also includes fees, so if you’re comparing lenders, look to the APR for a more complete picture of your expected costs.
What’s a good interest rate?
Interest is highly contextual, so there’s no magic number that you can point to as “good” in every instance. A good interest rate can depend on the following factors.
- For investing: type of savings account
There are two main types of savings accounts: traditional and high yield. Most brick-and-mortar banks offer only a traditional savings account with a very small APY. Though this won’t generate much interest income, working with a bank where you’re already an established customer can be convenient.
A high-yield account might offer interest rates that are between 1% and 5% higher than those of a standard savings account, depending on the bank and the overall economy.
For borrowing: type of loan and credit score
Interest rates for loans vary widely by the type of loan and the borrower’s creditworthiness.
Your personal and business credit scores also make a difference. Borrowers with a strong credit score and long business history can get better interest rates than those without.
For everyone: the federal funds rate
Interest rates are closely tied to the federal funds rate, which is the interest rate set by the Federal Reserve to guide economic policy. The federal funds rate is then used to inform the prime rate, which is given to the very highest-quality borrowers.
Interest rates for borrowers might be a little or a lot higher than the prime rate depending on the type of credit you’re pursuing and your credit history. For high-yield savings accounts, interest rates will fluctuate within a smaller range based on the federal funds rate and other broad economic factors.
The best way to tell whether you’re getting a good deal is by doing your research. Look at pricing for similar services across a few well-regarded financial institutions to get a sense of what’s normal. It can also help to check rates frequently because they can fluctuate often.
Put your money to work
Whether you want to open a business savings account or take out a loan to fund a strategic move, a Chase business banker can help you decide or select the right services.
