by Kate Flaxx

Created on: August 05, 2010

Simple interest and compound interest are two very different interest types.

Simple interest may be calculated on a number of different financial services products.

The same applies to compound interest, although this type of interest usually works in favour of the customer.

It’s common to see simple interest applied to loan products such as mortgages and personal loans while compound interest is usually applied to savings accounts like term deposits and some online accounts.

Just as an example, and for ease of understanding, we’ll look at how compound interest and simple interests affects a savings account.

Bank A offers a savings account with a simple interest rate of 6.5% per annum while bank B offers a savings account with the same rate per annum, but compounds the interest.

Bank A is calculates simple interest as a flat out rate for the year.  If someone was to open a savings account at Bank A with an amount of $2000, how much interest would they earn after one year?

The answer to that is very easy because it’s calculated with simple interest.  The amount would be $2000.00 x 6.5% (0.065) x 1 (for one year).  This would mean that the person putting their money into bank A would earn $130.00 interest in one year on a simple interest

If this amount was deposited into bank B, who compounds interest daily, then the calculation and end result would be different and would represent a higher earner over one year for the person saving.

Instead of the 6.5 percentage per annum being calculated as a whole, because it is applied to bank B’s account daily, the percentage is broken up from a per annum percentage and converted to a daily percentage.

This daily percentage on the account would be 6.5 divided by 365 and then converted to a decimal.  This would equal a daily compounding percentage of 0.00017808219.

At the end of the year, bank B’s daily compounding account would earn the saver almost $135.00 in one year on top of their principle amount of $2000.

Because Bank B’s account compounds on a daily basis, the saver is effectively earning interest on top of interest.  The small interest rate is applied to the principal amount and then the next day, the small interest amount is applied to the equal total of the previous days, principal + interest. 

Compound interest may be charged to savings accounts at different intervals, for example, some savings accounts apply daily interest at monthly, quarterly or annually intervals.

Most financial institutions will have the way that interest is calculated readily available.  It is something that is worth asking about especially if compound interest is an appealing way to contribute to savings.

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