The phenomenon is not new! In 2015, Standard & Poor’s Rating Services conducted a survey based on interviews with more than 150,000 adults in more than 140 countries. According to this survey, which is a little dated but still relevant, only 53% of Luxembourg’s population have basic financial education knowledge! To reach this conclusion, the survey assessed knowledge of four basic concepts – basic numeracy, interest compounding, inflation and risk diversification by asking the following questions.
Basic numeracy (interest). Suppose you need to borrow $100. Which is the lower amount to pay back: $105 or $100 plus three percent?
Compound interest. Suppose you put money in the bank for two years and the bank agrees to add 15 percent per year to your account. Will the bank add more money to your account the second year than it did the first year, or will it add the same amount both years?
Inflation. Suppose over the next ten years the prices of the things you buy double. If your income also doubles, will you be able to buy less than you can buy today, the same as you can buy today, or more than you can buy today?
Risk diversification. Suppose you have some money. Is it safer to put your money into one business or investment or to put your money into multiple businesses or investments?
Only 57% of the respondents from Luxembourg gave the correct answer for basic numeracy, 51% for interest compounding, 67% for inflation and 53% for risk diversification. And for you, what is your score?
Even if the answers seem obvious to many of you, it is always useful to remember what these four basic principles are. To start, in this article, we will discuss interest and compound interest.
The simple interest method
Interest is the price you pay to borrow money. As you repay the loan over time, a portion of each payment goes toward the amount you borrowed (the principal) and another part goes toward interest costs. How much loan interest you charge is determined by various factors, including your credit history, annual income, loan amount, loan terms and the current amount of debt you have.
If you use the simple interest method, it is easy to calculate loan interest. First, you need your principal loan amount, interest rate and the total number of months or years you will repay to calculate the overall interest costs. Then you use the following formula: Principal loan amount x Interest rate x Number of months or years in term = Total interest paid.
For example, if you take out a five-year loan for €100,000 and the interest rate is 2 percent per year, the simple interest formula works as follows: €100,000 x 0.02 x 5 = €10,000. If you use the daily simple interest formula, the interest due by day is €100,000 x (0.02 365) = €5.48.
Compound interest and the Rule of 72
There is an often-told story that when Albert Einstein was once asked what humanity’s greatest invention was, he replied: “Compound interest”. Compound interest occurs when interest gets added to the principal amount invested or borrowed and then the interest is applied to the new principal. In other words, it is an interest on interest, which leads to exponential growth. Compounding can work to your advantage as your savings and investment grow over time or against you if you are paying off debts.
How does interest compound work? Suppose you put €10,000 in a savings account with a 1% interest rate that compounds annually. At the end of the first year, you will have €10,100 (10,000 + 10,000 x 1%). At the end of the second year, you will have € 10,201 € (10,100 + 10,100 x 1%). Instead of calculating interest based on your original principal, compounding interest calculates your annual interest based on the principal plus any previous interest you earned on that principal.
Calculating compound interest may sound complicated, especially if you don’t have a computer spreadsheet handy. Fortunately, there is a simple tool that you can use to make calculations in your head. It is not precise as a spreadsheet but can be really effective in helping you make decisions. It is called the Rule of 72. To figure out how long it will take to double your money, you divide 72 by the interest rate you expect to earn on an investment. So, in the example above, it will take 72 years (721). If you want a faster return, it might be time to consider other investments!
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