Other than giving us discounts at Ross, what are percents good for?
Well, we don't always have to spend money to save it. Instead, we can make an investment or tuck it away into a savings account. Banks and investors actually pay us to do this by offering interest rates, usually given as—you guessed it—percents.
The amount of interest we earn, I, depends on four factors:
- the principal, P
- the interest rate, r
- the time, t
- how often the interest is compounded
The principal is the original amount of money you put into the loot. Whether you deposit $30 into a savings account or invest $500,000 in your cousin's startup company, that's the principal. Just to be clear, we aren't talking about your principal, Mrs. Lipschitz.
The interest rate is the percent of the principal that you earn. The higher the interest rate, the more money you'll earn. (Note: this is the opposite when taking out loans. Loans with high interest rates mean you'll have to pay more money back. It's a good lesson in context.)
The time we're talking about is the amount of time you let your investment simmer. The more time you leave your savings alone, the more you'll have saved up. (On the flip-side, the longer you leave your debts and loans unpaid, the more you'll owe in the long run.)
Compounding interest means adding the money you've earned from interest to the principal amount. It's a good thing for savings (but a bad thing for loans) because the interest rate will be applied to a larger balance. Basically, it means you'll earn (or owe) more money...faster.
We won't get into compound interest here, because that can get real complicated real fast. Instead, we'll talk about simple interest, or the amount of interest you can earn from the principal alone. That's right, Mrs. Lipschitz. Put down those knitting needles and pay up.
We can use a simple formula to calculate I: the interest you earn. If we know the principal P, the interest rate r, and the time t, all we have to do is multiply these three values together. As a formula, it looks like this:
I = Prt
When plugging values into the equation, it's a good idea to check for a few things. Our interest rate r should be in decimal form. Since percents are out of 100, it's easy to convert them into decimals. The interest rate and time need to have the same units. If you get 4% interest every month, you'll want to multiply that by the principal and the number of months you've had your investment, even if it's been 30 years.
Don't stress about calculating simple interest. After all, there's a reason it's called simple interest. And despite how much interest you earn on your principal, it's bound to be more interesting than your principal. Come on, Mrs. Lipschitz...look alive.
Mrs. Lipschitz?
Related or Semi-related Video
Finance: What are the components of a mo...1 Views
Finance Allah shmoop What are the components of a mortgage
payment All right so here's a weird thing about mortgages
When you borrow say four hundred grand buy a home
and say in a six percent fixed thirty year interest
you'll end up paying way more than the four hundred
grand just in interest Renting the money Think about it
Well you'll have a monthly pay payment of twenty four
hundred bucks and by the time you've made thirty times
twelve per year or three hundred sixty payments you'll have
paid some four hundred sixty three thousand dollars in interest
charges Seems like a lot of money to pay out
of your own pocket But since mortgage interest is usually
entirely tax deductible well the rial cost to most home
borrowers is actually meaningful E less than that six percent
interest maybe something closer to a three and a half
four percent something like that So while yes on a
total gross basis you will have paid out more than
the amount borrowed over the thirty year course in the
mortgage you'll also have been forgiven loads of taxes And
for what it's worth over most thirty year time periods
in history the market has gone up about eight to
ten percent a year on average Compound did something like
that So you feel the people mover floor moving fast
underfoot with inflation pushing things around as you go along
Well the money you borrow is the principal of the
loan and that number usually declines by a small amount
each month As you make a flat payment and it's
usually gradually paid off Check out what the principal of
four hundred grand looks like for the first twelve months
of payments right here Note that the flat monthly payment
is twenty four hundred dollars and see how the principal
payed as part of this payment loan thing there goes
from paydown of three hundred ninety eight dollars Teo Well
four hundred twenty a year later right Like you're paying
off principal little by little So you have less that's
attributed to interest And Mohr that's attributed to principal pay
down as you go along and note that this assumes
Ah flat monthly payment here Right You're paying the same
amount You're one you would You're thirty two thousand three
hundred ninety eight dollars and twenty cents on this particular
alone So after a year the amount owed an interest
is well just slightly last Here in this example it's
one thousand nine hundred seventy seven bucks down from in
a two grand and note what it looks like at
the end of each of the first five years That's
a big shift from almost entirely interest do now Principal
being ah meaningful part of it you got after ten
years right here and then at the halfway point in
fifteen years it's here So I noticed that the amount
owed at this point is roughly half the total Why
Because the lion share the pay down went to interest
in the first half of the life of the mortgage
AII those first fifteen years and well then in the
back half way more will be attributed to a principal
pay down than to interest Like check out what the
very last month's payment looks like It's just twelve dollars
of interest and two thousand three hundred eighty six dollars
of principle All of this is principal until well then
the balance is zero and we'll finally Then you will
have fully paid off your mortgage and own your home
Up Next
What is a mortgage? A mortgage is a loan on property. Obviously not many individuals, or companies for that matter, can or want to pay cash for the...
What is an Adjustable-Rate Mortgage (ARM)? An adjustable-rate mortgage is a mortgage that has a changing interest rate. Whatever it changes to is b...
An interest-only mortgage is a mortgage on which you only pay the rent on money borrowed, rather than on the principal.