When looking at any kind of financial product, it is essential to have a grasp of basic terms, particularly when it comes to interest payments or deductions. Simple interest and compound interest are two different ways of calculating interest accrued or incurred on an investment or a loan. Not only are they calculated differently, but they can result in wildly different totals, so you need to know the difference before you commit yourself to any kind of financial product involving interest payments.
Simple interest is calculated by taking a percentage of the principal sum in a financial product and adding it to the balance. For example, if you take out a loan of $100 with an annual interest rate of 5%, at the end of the year, you will owe your lender $105. The following year, a further $5 interest will be applied to the account, leaving a total debt of $110, and you will continue to owe an extra 5% a year until the loan is repaid.
Compound interest is different in that it calculates interest based on both the principal sum and any additional interest already earned. So take out a loan of $100 with an annual interest rate of 5% and at the end of the year you will still owe just $105. At the end of the following year, however, you will owe not just $110, but $110.25. This is because the lender has applied a 5% interest rate to the $5 which had already accumulated. While that doesn’t sound too bad, after two years you will owe $115.72, and after 20 years, when simple interest would leave you owing just $200 for your $100 loan, compound interest would work out at $265.33.
Fortunately, simple and compound interest rates generally favour the consumer. Standard loans and financial products tend to use simple interest, while compound interest is more commonly applied to saving accounts – in other words when you are receiving interest payments rather than owing the lender even more money!
Compound interest is a powerful way of increasing savings over the long term, and many people neglect to factor in the effects of compound interest on their investments, as it is so much easier to calculate simple interest over a long period of time. It is rare for a loan to be structured in such a way that you are liable to pay compound interest on the debt, but it is not unheard of, and yet another reason why you should absolutely always make sure you read the small print of any financial agreement before commiting yourself.