Understanding Money and its Importance : Simple Interest & Compound Interest: Article 5
Now I understand that Math may not be your preferred subject at all. However, I strongly recommend that you put in effort to understand this part of Math dealing with money and its value. It is easy and once understood will be useful for life.
If you are putting 100$ in the bank and the bank is promising you to pay back 110$, then following points must be remembered:
A) 100$ is called principal amount (The amount which you start with)
B) 10$ is interest (The amount which you earn on principal)
Now, “Interest” can be of two types — Simple Interest and Compound Interest.
If I keep 100$ in the bank which gives me 10% interest per year and keep taking out 10% interest or 10$ every year for spending, I am actually getting 10$ X 5 = 50$ at the end of 5 years. This 50$ is simple interest earned on the principal of 100$.
Assume that I don’t take any money out at all. So,100$ becomes 110$ at the end of 1st year. At the end of 2nd year, it becomes 10% more or 121$ and so on. This is called compound interest. At the end of 5 years, I’ll get a return of 61$.
Let’s see the calculation comparison as below in Exhibit-A.
So, you can see there is a big difference in simple and compound interest. If there is only one thing which you want to learn from this book, it is this: “Compound interest the 8th wonder of the world”. Application of this concept properly has the potential to make anyone very rich.
Let me tell you a story of two friends Adgam and Badgam. Adgam and Badgam were fast friends since early childhood. They played together and studied together and even started their careers in the same company. Adgam was interested in saving money and investing it while Badgam liked to have a car and a house. He started investing 10 years later. Both of them invested a total of 20,000$ and both of them earned 12% interest per annum (Compounded — not simple). At the end of 20 years, Adgam’s total amount was almost 1/3rd more than Badgam’s. Why ? Look at the Exhibit B below:
So, we learn a very important lesson here. It is critical to start early to get the benefits of compounding.
This is the fifth article in the series of articles I am writing to create interest and understanding about money for the youngsters, Teenagers and Millennials. If you find it interesting, please share it with people you know.
