Simple interest vs Compound interest

Understanding the way interest is calculated can help you make a more informed decision as to which product is suitable for you. This fact sheet explains how simple and compound interest are calculated. The interest rate is expressed as a percentage and generally given as a per annum (pa) amount; that is the percentage to be paid on the money for a 12 month period.

Calculating Simple Interest

Simple interest refers to paying interest only on the principal amount. To calculate the dollar value of the interest (i) you need to know the principal amount (p), the interest rate (r) and the period over which the money will be invested (t). It is calculated by multiplying the principal by the interest rate by the period of time invested.

So if we have an interest rate of 6% pa and we are going to invest $3,000.00 over 5 years, the interest we will earn is:

Therefore, at the end of the 5 year period the total amount will be the principal plus the interest earned, so we will have a total amount of $3,900.00.

Calculating Compound Interest

Compound interest is accumulative, that is, interest is paid on the principal initially and then the next payment of interest takes into account the principal plus previous amounts of interest paid. Therefore, to calculate compound interest you need to calculate it year by year. Take the same example we used above, if the starting values are the same, our result will be:

Our second year will then use the new principle to determine the interest paid as below:

This follows through giving the following:

Year Principal Interest earned New Principal
1 $3,000.00 $180.00 $3,180.00
2 $3,180.00 $190.80 $3,370.80
3 $3,370.80 $202.25 $3,573.05
4 $3,573.05 $214.38 $3,787.43
5 $3,787.43 $227.25 $4,014.68

This gives a total amount of $1,014.68 interest being paid over the 5 year period and our new balance of $4,014.68. As you can see, compound interest will result in a higher dollar value of interest paid than simple interest.

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