Simple and Compound Interests: What They are And How They Work

Those who invest their money should fully understand the difference between simple interest and compound interest.

As a matter of fact, there is a substantial difference between the two concepts, which is important because some investments offer simple interest, while others compound interest.

Since the latter allows the capital on which they are calculated to increase over time, it is obvious that they are to be preferred over the former in long-term investments.

What is compound interest?

Understanding this concept in depth also allows you to comprehend how compound interest helps your investments. In practice, compound interest is calculated over the long term, considering an investment that offers a certain interest rate, either annually or in instalments over the course of 12 months.

Basically, each interest instalment is directly added to the initial capital, so that the interest paid from the second instalment onwards will be calculated on an increased capital. Thus, if an investment offers 5% interest, this initial capital will be 5% of the sum invested.

Thereafter, the amount by which you get the periodic 5% will always be greater, thus allowing you to obtain an ever-increasing remuneration, although the interest accrued will remain fixed at 5%. In practice, with compound interest, the capital is constantly revalued, leading to a good total remuneration.

Compound interest and capital

With compound interest the initial capital increases with each balance of interest, therefore the more frequently the interest is paid, the higher the remuneration will be. Interest is often paid annually, but it is not uncommon to come up with proposals with interest paid half-yearly, or even quarterly or monthly.

Even if the proposed interest remains fixed at 5% per annum, if it is calculated and paid several times a year, on balance, the sum obtained at the end of the year will be higher with compound interest.

It is also important to understand that this type of proposal is particularly attractive when considering a long-term investment, whereas on a short-term investment, of only one year for example, clearly, the incidence of interest could be minimal.

What is simple interest?

An investment which involves the accrual of simple interest works in a slightly different way. As a matter of fact, the interest is always calculated on the initial capital, because the remuneration obtained is deducted from the calculation unless the client has the option of reinvesting it; in this case, however, it is the client’s choice, not something that is done automatically as with compound interest.

Therefore, if you have an investment that offers 5% simple interest, the remuneration obtained will always be calculated on the initial capital, even when the investment continues for years. In this case, whether the interest is paid monthly or annually has less impact on the investment itself.

It is understood that the owner of the capital in the first case will be able to enjoy the interest every month, instead of having to wait until the end of the year.

Which type of interest to choose

It seems quite evident that compound interest can lead to a higher return. However, it must be made clear that not all investments offer this type of interest; in most cases, the offers include simple interest, which allows a precise annual return for a given period. On the other hand, the investments that allow for compound interest are those tied up with multi-year terms.

Not everyone is willing to keep money tied up for long periods of time, so these kinds of investments are not always considered particularly attractive. However, a better understanding of how compound interest works is enough to properly evaluate such proposals.

Also, because, even if you have to maintain an investment for many years, it is clear that the return is significantly higher than that offered by the classic simple interest rate.