Why Is Compound Interest Preferable To Simple Interest?

Let’s say you have a million dollars and want to live off interest rates. Does it matter whether you choose simple or compound interest?

For money reasons, you always want it to be compound. It grows faster. One is linear while the other is exponential.

Say we have a generous offer, 5% of simple interest per month. For $1,000,000, that’s $50K/month. Not bad.

And if you choose the compound interest, it’s generally lower. Let’s use 4% of $1,000,000.

But compound interest doesn’t consider just the original amount, but what you have in total. If you earned $1,020,000, next month would be 4% of that.

100/4 = 25

After 25 months, you will have $2,000,000. And 4% of $2,000,000 is $80K. Wait another 25 months, and it turns into $160K, $320K, $640K, $1.28M per month.

Which One Would You Choose

It can grow faster or slower, depending on the investment you make. So which one would you choose, simple or compound?

I would take both. And choose whatever makes you the most money right now.

Simple interest might be bigger than compound interest at first. So it’s the fastest way to grow your money.

Use simple interest in the short term to grow your account. Then, switch to compound interest.

Question: “If you find an income stream that doubles your cash, why would you want to take it out?”

It’s hard to find an investment that delivers consistently. But if you find it, it’s wise to do the following:

Some will want to withdraw everything right away. Others won’t take a single penny because they don’t want to miss out on the compound interest magic. We suggest you keep withdrawing a small amount (e.g., your monthly cost of living) to make sure the money is real.

Keep in mind that when you invest in a company, it’s their duty to be transparent with you. But you will never know if they’re telling the truth. If your online investment account says you doubled your money but can’t withdraw anything, it could be an HYIP scam.

Why Compound Interest Doesn’t Work

Do you know anyone willing to pay you unlimited money at an exponential rate? If there is, that company must really bring a lot of value to the market.

Look, results aren’t predictable. Those interest rates will lower after a few years. Companies know it, which is why they don’t guarantee they’ll make you money.

Let’s assume you have the perfect investment that doesn’t have that problem (maybe US Treasury bonds or index funds). Can you earn compound interest?

You can, as long as you don’t touch that principal. That’s the hard part.

You have to KEEP the amount

Imagine your investment reaches a point of 300% ROI over the years. As your money grows, so will do your challenges and expenses. You will find more and more excuses to withdraw that money and spend it on something.

And the later you withdraw, the more potential you lose.

EXAMPLE 1:

You invest $50 for 5% per month in compound interest ($2.5 per month). You earned a total of $100 but spent $90. With $10, you earn fifty cents per month. You lost 500%, but the amount isn’t a big deal.

EXAMPLE 2:

You invest $10,000 for 5% per month in compound interest ($500 per month). You manage to earn $3,000,000 (which would be $150,000 per month) but you buy a personal jet for $2.85M, leaving $150,000.

5% of $150,000 is $7.5K, which is 20 times less than $150K. $150K was once your monthly return, but it will now take you 20 months to make that. You lose $142.5K per month.

That doesn’t mean you should never withdraw money. As long as you keep ~95% of the amount invested, you’re good.

Inflation slows things down

Compound interest works. But in order to get value from it, you must be either retired or not know what to do with your money. There are so many faster ways to grow your wealth.

Traditional institutions can’t offer you a rate that’s high enough to make profits. For example:

It may not be a lot. But your losses compound on each other just like your profits do. The longer you invest, the more you lose on inflation.

Here’s the conclusion. Compound interest isn’t some genius strategy to make free money. It’s a requirement to avoid losing your money on inflation and fees. You will most likely keep your amount or profit a bit if you’re lucky.

Does Simple Interest Make Sense?

Then why would you want simple interest? Well, it benefits the person who’s paying the interest.

Imagine you owe $100,000, and you won’t be able to repay until 24 months later. Would you rather:

If you choose compound, the debt may grow faster than you can earn money. But if you choose simple interests, it’s more manageable.

You want to earn compound interest but pay simple interest.

The Bottom Line

Compound interest will keep you rich, but it’s not enough to become rich (unless you want to get rich slowly). If you take this investment vehicle, make sure:

The more money you put down, the more it generates.

Now, should you choose annual or monthly compound interest?

If you want to increase your cash flow, you can choose the monthly plan. But companies generally offer higher rates for annual plans (because the money has more time to compound).

Also, any long-term investment (untouched for over a year) is exempt from capital gains tax.

And if you don’t have the willpower to place big bucks on those funds, start allocating money instead. You can invest $15 for every $100 you earn at your job, for example.