It is important to understand the difference between ‘simple’ interest and ‘compound’ interest when taking on any loan. The difference in the two interest calculations is very important and a prospective borrower needs to be aware of these differences as the cost of a loan, over its full term, will be much higher with compound interest than with simple interest.
Definition and description of simple interest
Simple interest can be defined as “interest that is calculated on the original sum (the principal) of a loan, the borrower only pays interest on the principal amount”.
An example of a simple interest loan would be as follows:
£1000 borrowed for one year at an annual, simple interest rate (todellinen vuosikorko) of 20% would mean that the borrower would repay £1000, the principal, and an additional £200 in interest that would make the total repayable as £1,200. This would usually be repaid in 12, equal payments of £100 during the one year period of the loan.
Simple Interest on 12 month loan
- Amount of Loan £ 1,000
- Annual interest rate 20%
- Interest payable on loan £200
- Total repayable by borrower £1,200
- Monthly repayments for one year loan £100
Definition and description of compound interest
The definition of compound interest is significantly different to that of simple interest in that the interest is calculated on the original (principal) amount and also, significantly, also on the interest that is accrued during the previous period of the loan. The borrower is literally paying “interest on interest.”
An example of a compound interest loan for £1000 over a 4 year period would be as follows:
£1000 + 20% = £1200 after one year,
£1200 + 20% =£1440 after two years,
£1440 + 20% = £1728 after three years,
£1728 + 20% = £2073.60 after four years.
The difference in the amount repaid when calculating a loan using simple interest is significantly lower than when using compound interest. The simple interest loan would have attracted interest payments of £800 during the four year loan period while the compound interest loan would have attracted interest payments of £1073.60 during a similar four year period.
Formula for calculating simple interest
n=term of the loan
Using the above formula we can calculate simple interest of 20% on a $1,000 loan taken out for a 4 year period and find that the interest payable is calculated as 1,000 x 0.05 x 4 = $200.
Interest on the loan would be $50 annually or $200 for the four-year loan period.
Calculating compound interest
0 (Start of Loan)$1,000.00
Initial interest ($1,000.00 × 10% = ) $100.00
After one year $1,210.00
After two years $1,331.00
After three years $1,464.10
After 4 years $1,610.51
Total interest paid on the loan during the four year period would be £610.51
The difference in cost of a loan taken out with compound interest when compared to a loan taken out with simple interest is always significant and this is more important where the repayment period covers a longer period. When banks lend money to responsible borrowers and businesses they do so by using compound interest. Consequently, the cost of borrowing from a bank or other similar financial institution can be very expensive for a long-term loan. For many people their largest purchase will be their home, this will be mostly financed by a mortgage from a bank or building society. These mortgage loans will be calculated over a period of 20 or more years using compound interest. The need to make regular payments on any loan is important. This is even more the case where compound interest is being applied as any unpaid amount occurring during a repayment period will attract further interest during subsequent periods and this will be the case until the loan is successfully repaid in full.
To read more on topics like this, check out the Financial Tips category.
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