When it comes to interest, it isn’t always ‘simple’ – but it doesn’t need to be difficult to understand. Basically, interest usually falls into one of two groups - simple or compound. But what is the difference? And why did Albert Einstein reportedly call compound interest the eighth wonder of the world? Here’s a quick crash course.
Let’s take the example of savings accounts. Interest is the money paid to you by the bank
as a reward for keeping your money with them. The interest is shown as a percentage, usually
expressed per year, and is calculated based on the amount of money in your account. Simple interest is just that - simple. The interest rate is applied to the amount in your account (principal only).
For example, if you have $1,000 earning 2% interest for a year, it would grow to $1,020 when the interest is paid at the end of the year. So the interest you receive over a certain period is a fixed percentage of the principal amount you deposited.
You could have heard it referred to as ‘magical’ interest, and there’s a reason for that. Basically, you earn interest on the money you’ve deposited, and also on the interest you’ve already earned. In other words, your interest earns interest.
If you deposited the $1,000 into an account with compound interest earning 2% per year, compounded monthly, you would have $1,020.18 at the end of the first year. This is because the interest is applied after the first month, then the interest rate for month two is applied to the principal and interest, and so on. So your money can grow at an accelerated rate over time. The impact is harder to see in the early years, but eventually, it becomes quite pronounced.
Looking at our examples over a number of years can demonstrate the difference. Let’s say you invested $1,000 every year into an account earning 5% simple interest each year, and decided to withdraw the interest at the end of each year. Over the 30 years you would have saved $30,000 and earned $23,250 interest on top of that. If you made the same investment with interest compounding monthly, with the same savings and 5% interest rate over the same 30-year period, your interest earned would increase to $41,247.57, with a total balance of $71,247.57. That’s almost double the amount of interest earned when compared with our simple interest
