When you must choose between two things, do you weigh the advantages and disadvantages and then choose? As with everything, this can hold true with simple interest vs compound interest. Each has its own advantages and disadvantages.
Read through the boxes below to learn more advantages and disadvantages to simple and compound interest. (Note: For comparison, presume the interest rates and principal are the same.)
Advantages
Simple Interest
- Interest does not change over time.
- Monthly payments are the same amount every month.
- Loans can be paid back early by paying more than what is owed in any given month.
Compound Interest
- You earn more money on investments due to gaining interest on previous interest.
Disadvantages
Simple Interest
- Investments will make less money.
Compound Interest
- Loans/Credit Cards will cost you more in interest.
Suppose that Ryu is looking at credit card plans. He always pays his bills on time, and usually in full, so he is not too concerned about the type of interest he will be charged. He finds a credit card that comes with great rewards and perks but at the cost of an 18% interest rate, compounded quarterly (four times a year). After months of using this card, he starts to have trouble paying his bill in full each month. This has caused his interest to skyrocket thanks to the large interest rate and the interest being compounded quarterly.
Question
What could Ryu have done instead?
Paying compound interest on credit cards causes you to pay more in the long run. Ryu should have chosen a credit card with a much lower interest rate, and/or chosen one with interest that is compounded less often than quarterly (recall that the more often interest is compounded, the more interest you will have to pay).
