Simple or Compound Interest? Understanding What Difference it Makes
A few things have been said about compound interest elsewhere on this website, but all that underlines what a power-tool for wealth-building it is. Though not easily understood by many, compound interest has long been identified as a weapon any individual can deploy to achieve financial success. That's clearly why is has been described in such superlatives as the one widely credited to Albert Einstein, renowned scientist, said to have referred to compound interest as the 8th wonder of the world. This piece is however to put simple and compound interest in perspective and help you get the best of interest benefit, when you have the opportunity.
What Interest Is
Interest is the fee or price paid for borrowed money or other asset. Other assets that get borrowed to attract interest payment are in such financial arrangements as hire purchase, leases, etc. Now, if you are wondering how this explains the interest you get paid when you deposit money with your bank, you only need to realise that the roles are merely reversed in that circumstance: its' the bank that borrows from you, but it's borrowing all the same. So, when you borrow from the bank, you get charged interest for the use of their money and when you lend to the bank, you receive interest. Interest is usually stated as an annual percentage rate. All this is probably known to you, but how do you get the best out of your interest earning or limit the interest charge you suffer on borrowed money? Understand workings of compound interest and apply that knowledge.
Simple or Compound - the Difference
Simple interest is the interest computed on borrowed money based on the principal sum, where the principal is not increased by earned interest. Simple interest is therefore on a fixed principal sum, meaning that the amount earned from month to month can only vary on the basis of the length of each month. The interest earned is taken out and not added to the principal, so the latter does not grow. The future value is therefore given by the simple formula:
- FV = PV [1 + ( i x n ) ]
- FV - future value (or maturity value)
- PV - principal or present value
- i - interest rate per period
- N - number of periods
What happens here is that if you deposit money with a bank for a fixed tenor, say 6 months, the banks calculates interest and pays to you at maturity. This calculation, under simple interest, assumes that over the entire stretch of 180 days, the money you loaned to the bank was the same principal amount, each day.
Compound interest, on the other hand, is paid on the basis of regular periodic accretion of interest to the principal. The period of interest calculation and accretion is stated and can be monthly, quarterly, half-yearly, yearly or other stated interval. In effect, the principal sum will continue to grow, as more interest is added to it. That is the big difference between simple and compound interest. The latter grows the principal sum over time and this results also in increasing size of interest, progressively. This organic, exponential growth is what gives compound interest the power to explode your wealth, when given enough time. That is also why you seem to pay through your nose when you borrow from banks. Banks understand the working of interest. When you borrow, they compound your interest payment, and when you fix money, you get simple interest. Check your loan account and you'll see that interest is not only charged monthly, but becomes part of and increases the principal on which you pay the next month's interest. Note the exponential factor in the formula for future value in compounded interest:
- FV = PV (1 + i)n
- FV - future value (or maturity value)
- PV - principal or present value
- i - interest rate per period
- N - number of periods
The exponential function "n" is an indication of how compound interest more rapidly grows the value of your investment or debt.
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Putting it To Work
What does this distinction really mean for you? It is that compound interest is what to aim for on your investment. When you invest, seek to gain the benefit of compounding. That requires having interest rolled over with principal. In practical terms, it means that instead of locking a deposit for six months at a stretch, for instance, you're better off placing for tenors of 1 month, with rollover of principal and interest at each maturity. The only way this might hurt is where you can safely predict a significant fall in interest rates and find the need to lock in for a longer period. More importantly, the working of compounding advises logging into its impact for a long period. Its effect on the future value grows exponentially, proving exceptionally rewarding over many years. Learn more on this in this article.
Also, when you borrow, realise that interest on money you borrow is compounded. That is why you must service your account. Clear due interest before it becomes part of the principal, growing the burden. And when you can pay off a facility, why carry the burden of interest payment?
So, don't lose out on the benefit of the knowledge about compounding, whether you're lending or borrowing. It makes a lot of difference.
