Simple vs. compound interest: what’s the difference?

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Interest is a bit of a double-edged sword for many of us. You may only think of it as something you have to pay (especially if you have a credit card or a loan) but if you’re smart about it, interest can work in your favour as well, especially on investments or savings.

And let’s face it: earning interest on our money is something we all want to do—preferably while we sleep, right? Knowing a bit about how interest works is all part of good financial management—and it’s as important as choosing the right super fund or insurance policy for your needs.

Let’s break it down so you can work out the best type of interest for your circumstances.

Simple interest vs. compound interest

Knowing the difference between simple interest and compound interest is essential if you’re trying to choose a loan or the best account in which to park your savings.

Simple interest

If you’re a borrower… simple interest is added to the outstanding balance of your loan, but the interest rate stays at a fixed percentage of the original amount borrowed (the principal).

If you’re an investor… simple interest is calculated on your initial deposit only, and not on the earnings you may accrue in interest over time.

Compound interest

If you’re a borrower… compound interest builds on the interest accumulated. So if you have a credit card debt and you only pay the minimum repayments, this can lead to higher repayments over time because you’re paying interest on the interest as well as the principal.

If you’re an investor… your money earns interest and your interest earns interest, which can help grow your savings faster.

How exactly do simple interest and compound interest work?

Good question! Let’s look how these types of interest work in a basic saving scenario where you dumped $10,000 in an account and left it to let the interest grow over a period of five years.

Simple interest: if your account paid a simple interest rate of 3% per year, you’d earn $300 interest per year on your initial investment and $1,500 over 5 years.

Compound interest: If your account paid out monthly compound interest at the rate of 3% per year, you’d earn $1,661 in interest over 5 years—an extra $161 overall- because the interest would be calculated on the principal amount plus the interest being accrued each month.

How to turbo-charge your savings

This is where compound interest can really make a huge difference to growing your wealth.

If you chose the compound interest account at 3% and threw in an extra $100 per month on top of your initial $10,000 investment, you’d end up earning a whopping $2,139 in interest at the end of the five-year saving term! It’s because you’d be earning interest ON your interest. Your total investment would then be $18,139 at the end of the term.  

Playing around with an interest calculator can show you a high level glance of just how your money could grow over a number of years. Try this simple interest calculator or a compound interest calculator like this one—we reckon it’ll help motivate you to start socking away those spare funds!

Earning vs. paying interest

If you’re borrowing money or taking out a credit card, be aware of compound interest and how it could impact you financially. For example, if you deferred your mortgage (as many Australians have done during COVID-19), the interest on your ‘paused’ repayments continues to compound, leading to higher repayments when you do start paying the home loan again.

For investments, accounts that calculate compound interest more frequently (daily or monthly) can grow savings faster than a simple interest account. That said, some simple interest accounts such as term deposits may be more flexible than getting locked into a high interest rate subject to not withdrawing funds.

Prepare today for a secure tomorrow

Knowing how simple interest and compound interest work is essential preparation if you’re applying for a home loan, looking into investment options, or researching good account options for your savings.

Of course, this is general information only and not financial advice. You should seek the advice of a professional to assist you with your personal situation.

No matter how much you plan and prepare for things, sometimes there are circumstances that are out of your control. Having a plan to protect your business is something all business owners should consider. Find out more about business insurance and compare today with Choosi.

Posted: 15 Dec 2020

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