Simple interest does not factor in the interest from previous years and only includes the original principal amount in the calculation. That differs from compound interest, which takes the original amount invested or borrowed and the past years’ interest into account.
As an investor or saver, knowing the difference between simple and compound interest can help you turn a profit or cut the cost of your borrowings.
Simple and Compound Interest Explained
Simple interest is the interest you earn or pay at the same rate every year. It is based on the original principal amount of a deposit or loan.
On the other hand, compound interest refers to interest you earn on previously earned interest. It is based on adding the principal amount with interest accrued over the previous period. Therefore, you are compounding your returns as an investor or saver.
Calculating Compound Interest
The variables involved in determining compound interest are as follows:
- Principal
The initial amount invested or borrowed used to calculate interest. The principal can go up or down depending on the deposits and withdrawals.
- Interest Rate
The price of borrowing or the gain from lending. The higher the interest rate, the more money you can make or pay. Interest rates can be subject to change or fixed for a certain time.
- Duration
The length of time, which can be fixed or open-ended, you plan to invest or borrow the money. Duration is a crucial component in compound interest because the longer the money stays invested or deposited, the higher the interest due to the compounding effect.
- Frequency
Refers to how often you will add interest to the principal. Your interest could be compounded daily, monthly, quarterly, semiannually, or annually. The more frequently you compound, the quicker the balance will grow.
It’s also important to learn about the annual percentage rate (APR), annual equivalent rate (AER), and annual percentage yield (APY).
- APR
The annual interest charged on loans, mortgages, credit cards, and other borrowings on a simple interest basis. APR is more associated with credit accounts and consists of upfront fees plus the interest rate stated on a loan.
- AER
The interest or return earned on investments, factoring in the frequency of the interest payments on a simple interest basis.
- APY
The annual interest earned on investments, considering how often you compound. The APY is a better measure of your returns than AER if you don’t plan to take out some of your money.
Keep in mind that loans charge a higher effective interest rate than the APR if the interest is compounded, and you cannot make overpayments to counter it.
Usage of Simple and Compound Interests
Simple interest is ideal on loans, while you would want compound interest on investments, although that happens quite less often.
- Investments
Interest or returns can be compounded in many investments, including equities and savings accounts, with bonds and gilts being exceptions, as you only pay simple interest called the coupon rate.
- Borrowings
Borrowings, including personal loans, car loans, and short-term consumer loans, usually charge simple interest. On the other hand, the interest on student loans and credit cards is compounded, meaning your debt can increase rapidly if you don’t make the repayments.
Mortgages, meanwhile, can use simple or compound interest, depending on the type:
- Repayment mortgages are based on compound interest, but the monthly and overpayments cut the principal or outstanding balance as well as the interest payable.
- Interest-only mortgages charge simple monthly interest, and a separate lump-sum payment is needed for the principal at the end of the mortgage’s term.
Taking Advantage of Compound Interest
There are several ways you can take advantage of compound interest and avoid over-paying for borrowings:
- Opt for simple interest loans
Simple interest loans require you to pay less than a compound interest one. For example, a personal loan is based on simple interest, while a credit card is based on compound interest.
- Choose low-interest rate options
In the US, the current average interest rate on credit cards is around 23.4%, while personal loan interest rates range from about 6% to 36%.
- Find flexible loans
You can find some loans that will let you make overpayments without dealing with a penalty fee, helping lower your interest cost. Typically, personal loan providers have the legal responsibility to permit early repayment, which can include one to two months’ interest fees.
- Focus on your most expensive debt
You should first pay down the most expensive debt, meaning the debt that compounds the most. For instance, choosing credit cards over personal loans as your first repayment priority.
You can also use your returns’ compounding ability to increase your investments’ value:
- Make the most of your investment period
Remember that time is key to compounding. Therefore the longer you invest, the more earnings you can generate as you provide compounding more time to work its magic.
- Protect your earnings with wrap accounts
Consider using wrap accounts or tax wrappers to protect your investments from capital gains and income tax. Investments in accounts like an Individual Savings Account (ISA), Self-Invested Personal Pension (SIPP), and Junior ISA are free from such taxes.
- Reinvest your income or dividends
Instead of withdrawing the interest in your savings account, keeping it there can help you gain from next year’s compound interest. With shares, you have the option to reinvest the dividends by owning additional shares instead of cashing them out.
If you invested in funds, you could invest in accumulation over income units, which use any income made to purchase more units in the fund.
Compounding in Reverse: Management Fees
You also need to consider the impact of compounding on fees, as it can significantly reduce the value of your investment portfolio.
Management fees can be pretty high in investing and more expensive than they initially seem due to the opportunity cost they represent. Every dollar you pay is a dollar less that can compound returns on your behalf. Therefore, the impact on your earnings can be higher than the fee itself.
The difference in fees can eventually make a big difference to your portfolio’s value because of the compounding of the returns and the fees, even if there is only a small difference.
