What you need to know: Simple Interest vs Compound Interest.

14 Jul 15

What you need to know: Simple Interest vs Compound Interest.

It’s extremely useful to know the difference between Simple and Compound interest, when working out the total cost of borrowing on credit cards loans, savings and investments.

Most times when we think of interest we consider only the simple interest which is calculated by taking the principle loan amount and multiplying it to the interest rate and then multiplying that to the repayment period. So take for example a £1000 loan borrowed at an annual interest rate of 5% over 3 years. Below shows the total amount to be repaid and the simple interest,

Full Repayment Amount: PRINCIPAL X RATE X INTEREST

Simple Interest = p x r x t

=£1000 x 0.05 x 3 years months

= £150

Full Repayment Amount: =£1150

In this calculation simple interest is £150 and the total amount payable is £1150.

Compound interest is a bit more riveting, if you like that sort of thing!

When considering the compound interest, after calculating the interest on the principal loan amount, the interest is added back to the principal. Interest is then calculated on this amount for the next period. In this way interest is compounded.

This is how it looks when that same £1000 loan is taken out over3 years at an annual interest rate of 5% and the compound interest is calculated.

Year 1: £1000 x 0.05 = £50

Year 2: £1050 x 0.05 = £52.50

Year 3: £1102.5 x 0.05 = 55.13

Compound Interest = £157.63

Full Repayment Amount: £1157.63

Compound interest works out more than simple interest, as you would expect. Great news if you are making an investment. And, useful when deciding to take a loan. Many lenders charge simple interest on short term loans which can make them preferable to longer term loans. In a situation where you need money fast and you expect to pay the loan off quickly, a short term loan where simple interest is calculated may be just what you are looking for.