Simple Vs Compound Interest on Savings

Simple vs compound interest on savings

When you set aside money for saving, you can opt to deposit it in a savings account as normal savings or a certificate of deposit in a financial institution or hold it in other traditional forms. When you set money aside in a savings account, you are not only assured of its safety but also returns in the form of interest. Interest, therefore, is the amount of money a borrower is expected to pay as the cost of debt or the amount a holder of a savings account receives over an agreed period. Basically, when you deposit money in a savings account, it is the equivalent of lending the money to the bank, whereby the bank can utilize the money and pay you interest at the agreed rate. The focus of this article is on interest on savings. Money in a savings account can either earn simple or compound interest, which is mainly calculated as a percentage over a determined period. It is essential to understand the two types of interest to understand how money in the savings account earns interest.

· Simple interest

Simple interest is the interest that is only calculated on the principal amount deposited. The calculation of this interest does not incorporate the interest that has accrued over the period. Simple interest is easy to calculate because it is determined as a percentage of the amount deposited. Assuming you deposit $5000 at the beginning of the year, and the account pays simple interest at the rate of 5% per annum, the interest on the savings at the end of the year will be (5%×5000) which will be equal to $250. At the end of the second year, the interest will still be 5% of $5000 and not 5% of the balance in the account ($5250). Hence, simple interest is calculated using the interest below:

Simple interest ꞊ P × r × n

Whereby; P is the principal amount deposited, r is the annual interest rate, and n is the number of years applicable on the savings.

· Compound interest

Compound interest, on the other hand, is the interest earned on the principal amount and any other interest accrued over the previous periods. This means that unlike simple interest compound interest is earned on the balance in the account and thus accrues over time. Under compound interest, interest can be compounded quarterly, annually, or semiannually. For instance, if you deposit $5000 in your savings account that pays interest at the rate of 5% at the beginning of the year, the compound interest at the end of the year will be $250, which is (5% of 5000). However, at the end of the second year, the interest will be $262.5, which is (5% of 5250). This will be the case even in the subsequent years and interest earned will be increasing each year because it is earned on the total balance in the account, which is the principal amount plus the accrued interest.

Compound interest over the subsequent years is calculated as follows:

Compound interest ꞊ P(1+r)n – P

Where P is the principal amount, r is the interest rate, and n is the number of years.

Under simple interest, the interest earned over the periods is constant. However, under compound interest, interest keeps increasing over the period. Hence, if you are saving, an account offering compound interest will be more appropriate since it will yield more interest. However, if you are borrowing, a debt with simple interest will be more appropriate because you will pay constant interest over the period, which will be much lower at the end of the loan period. This means that the cost of debt under simple interest is lower.