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A Look At Compound Interest

Interest rates. They are important but also rather boring to understand! And yet we need to understand them as they affect everyone who takes on credit in any form. The problem is, there is more than one type. So let’s take a look at compound interest.

Simple Interest or Compound Interest?

Compound interest is the addition of interest to the principal sum of a loan or deposit. Thus it is essentially interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Simple interest is calculated from the original amount, not the new amount after periodic interest is added to the principal sum. So compound interest will add more on. 

An Example

You borrow £100, which you intend to pay back two months later. Interest is applied at 10% each month at 10%. An unlikely scenario, but used to show how interest works. With simple interest, you would pay £10 interest after first month, and £10 again the second month, so £20 interest in total. However, with compound interest, you pay £10 interest too the first month. But the second month, you do not pay interest on the initial £100 borrowed. You pay 10% of the £110 amount that has had interest added after a month. So you pay £11 the second month. And if the loan was longer, you would pay in the third month 10% of £121. So you can see how interest ramps up compared to a simple interest formula.

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Not A Concern For Most 

In 2015 the FCA decided that short-term loan lenders could only calculate interest according to the simple interest calculation, The main reason for this being to make loans more affordable in the UK, and so that the interest calculation simple.  Importantly, simple interest is easier for borrowers to understand. They understand what needs to be paid back, as the interest added is constant.

Compound Interest – Advantages

Naturally as a loan broker we have looked at how compound interest can affect you as a borrower. But of course, if there are losers with compound interest, there must naturally be winners too. And so if you have savings with such an interest system, you will gain more money by using compound over simple. The more money you have, for longer, the more it will add onto your original amount. Even if you do not add to your savings, they can continue to grow.

Calculating Compound Interest

This may not mean much to you, as it does not for me, but here goes! The agreed formula for calculating compound interest rates is P = C (1 + r/n)nt – where ‘C’ is the initial deposit, ‘r’ is the interest rate, ‘n’ is how frequently interest is paid, ‘t’ is how many years the money is invested and ‘P’ is the final value of your savings.

Is that clear?! If you are not that familiar with equations, you do not need to worry about trying to plug in all the numbers yourself, as several tools exist online that can do it for you.

 

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