Interest is the cost of borrowing money, where a commission is paid to a lender in exchange for a loan. Interest is usually expressed as a percentage, called interest rate.
For example, if you take out a loan from a bank, the bank will add interest (which is calculated over a period of time) to the total loan amount until you repay it in full. This is how the bank makes money.
However, interest can also work in your favor, as with savings accounts and term deposits. With these, you are essentially lending money to the bank, which will pay you the interest you accrue after a set period of time.
In both cases, the type of interest charged can be simple or compound interest. So what are the differences? What is better? Is there a better option? Also, how can you calculate the interest you will pay or receive? Let’s find out:
Simple interest is interest calculated on the original amount of a loan or the initial contribution to a savings account, also known as the “principal” amount.
It is best understood in relation to compound interest, which we will come to later.
Unlike simple interest, where interest is paid at the end of a specific period of time, compound interest is based on the principal amount. In other words, it snowballs.
You could have a daily, monthly, quarterly or even annual compound interest rate, depending on the type of financial product you are dealing with.
The answer depends on whether you are the borrower (as in the case of a personal loan or a home loan) or the lender (as in the case of a term deposit or a savings account).
In the table below, we compare the same principal amount to which interest is applied, using simple, compound, and compound monthly interest.
We start with a principal of $10,000, with an interest rate of 5% (0.05) over a period of three years. You will notice that interest (I), when compounded, increases much faster over the same period of time – especially when calculated on a monthly basis.
In short, simple interest is better if you borrow and compound interest is better if you invest.
However, it’s good to know that banks know this too, which means they will often adjust their rates to account for the benefits of compound interest. That being said, compound interest will often grow your savings or investment at a faster rate than simple interest.