The difference between simple and compound interest is something of which anyone considering engaging in any form of borrowing should make themselves acutely aware. This is simply because the interest rate which is quoted is not always – or even usually – a direct representation of the percentage of the initial borrowed capital which one will be required to ultimately repay.
Simple interest is where the interest to be repaid on any form of capital borrowing represents a precise percentage of the actual amount borrowed. If one considers the example of taking a loan of one thousand currency units at a simple interest rate of five percent, this concept can be very concisely illustrated. As five percent of the one thousand currency units is fifty currency units, one simply adds the amount of capital borrowed to the amount of interest charged to determine how much money one will ultimately repay. In the instance of this example, one would be required to repay a total of one thousand and fifty currency units.
Compound interest is best described as being the form of interest where interest will be charged not only on the borrowed capital but on the interest which accrues on same and any fees or charges which may be levied in respect of the loan during the course of its term. If one considers the example above, the first step in illustrating the difference between simple interest and compound interest is to consider that the loan of one thousand currency units is taken at a compounded interest rate of five percent per annum over a period of three years.
If, in the unlikely event that one were not to make a partial repayment to the loan in the course of the first year, the same fifty currency units of interest would apply in interest charges. This would mean that one thousand and fifty currency units would be outstanding. If one were thereafter not to make any form of partial repayment in year two, however, the outstanding balance upon which one would have to pay interest at the end of that period would be one thousand and fifty currency units, meaning that the interest charged at this time would be five percent of that figure and equate to fifty-two and a half currency units.
The difference between simple interest and compound interest, however, grows more complicated still. As one is likely to be making partial repayments to the loan during the course of its term – most often on a monthly basis – the amount of capital upon which one is charged interest will be steadily decreasing. This means that mathematical formulae are usually used in the calculation of compound interest. By using these formulae, it is possible to establish what is referred to as an, “EAR,” – annual equivalent rate – which many countries require by law be communicated to the customer prior to the signing of the loan agreement and that this rate appear prominently on the said loan agreement. This is simply a representation of what one would be charged in simple interest terms per year over the course of the term of the loan and may well be very much higher than the apparent interest rate. This allows simple comparison to be made of the rates charged by different lenders.
It is worth noting also that any fees which one is charged for the taking of the loan in the first instance should be included in the EAR but any default charges which one later incurs will not. This would be the case where perhaps one misses a scheduled monthly repayment and is charged for doing so. If the charge is levied to the outstanding balance of the loan and is not immediately offset, this too will incur interest for the remaining term of the loan.
The difference between simple and compound interest is therefore extremely profound and essential knowledge for potential borrowers. If one does not take this factor in to account, one could face a very nasty surprise further down the line and may well commit to a loan agreement which is in real terms considerably more expensive than that offered by a lender’s competitors.