Simple interest is the most basic type of interest. Simple interest is just the interest rate percentage times the original capital (see diagram below). Some term deposit accounts are calculated using simple interest. In term deposit accounts the interest is usually calculated at the end of each year.
Under a simple interest loan, if I borrow $1 and the interest rate is 10% p.a. then I will need to repay $1.10 after 1 year.
Total repayment = Principle + Interest
= $1 + ($1 x 10%)
Some term deposit interest rates are instead calculated using compound interest. This also goes for credit card interest, personal and home loan interest or even the interest you get on most regular savings bank accounts. The interest on these types of loans and savings is calculated using compound interest. That is interest that is compounded. With compound interest, you pay interest on not just the principle but on interest you haven’t paid off yet from the previous times interest was calculated.
Another way of saying compounded is two things added together or something made bigger. This means that when compounded the interest is made bigger.
Compound interest is calculated more often than simple interest, sometimes daily. In principle it could be calculated every second! A compounded interest rate will generally be higher than the equivalent quoted interest rate using simple interest. Sometimes a lot higher. Banks usually quote the base interest rate and not the total compounded rate which you actually pay.
I am going to use “powers” in this definition. A power is simply when a number is multiplied by itself by the number of times specified in the power. For example 2 to the power of 3, which can be written as 2 x 2 x 2 (= 8) or in short hand as 2^3, which is the same as 2 x 2 = 4 and then that answer, 4 x 2 = 8. Technically this shorthand is only used in software packages like Microsoft Excel, the formal way to write a power is by writing a small superscript of the “power” to the top right hand side of the the number you are taking to the power, as you can see in the figure drawn below. When powers are used numbers can get big pretty fast – so when interest is calculated this way it can have quite an effect on the amount you end up paying on your debt or receiving on your savings.
If I borrow $1, and the interest rate is 10% p.a. but this time compounded daily. In the formula for compound interest (see diagram bellow), the interest rate, r = 10% or 0.1, the number of times compounded in the year or period, n = 365 days, the years or period, m = 1 year.
In the formula, n and m can refer to days, years, months, quarters, half-years or really any break down of a year. Interest rate, r is always a percentage.
At the end of one year I now have to pay $1.105.
Total repayment = ( 1 + 0.1/365 ) ^ (365 x 1)
= 1.00027397 ^ (365 x 1)
= $ 1.105
By compounding every day, the 10% interest rate is actually higher than 10% after 1 year. I am actually paying 10.5% interest.
This means the effective annual interest rate of 10% p.a compounded daily, is 10.5%.
If you have a bank account that pays interest, you want it calculated an paid as often as possible to get the highest possible interest on your savings. So you can earn interest on the interest you receive.
Most credit card interest is calculated daily. Interest is often also added to the account balance daily so you are quickly charged interest on your interest. This is why credit card debt can get so big so quickly.
I really wouldn’t recommend getting a credit card unless it’s a low-to-zero annual fee and low interest card. It’s much better to save up for what you need, that way you don’t pay any interest and best of all the bank actually pays you interest on your savings (if you are lucky enough to live in a country where interest rates are not zero that is!). Of course everyone’s circumstances are different, that’s just my own personal preference. Unfortunately sometimes it is difficult to pay for large cost items without a credit card because some retailers don’t like to accept large cash payments or a prevented by law from accepting such payments. For those types of purchases I do use a low interest rate, low fee credit card and pay the money back onto my credit card balance almost right away out of my savings so that I am not in any debt and do not owe large amounts of interest (if any).