What are the different types of interest?

Many of the financial transactions you make involve earning or paying interest in one form or another, which may not always be easy to understand. You may have learned about calculating simple interest and compound interest in high school but rarely needed to do the same sums in real life. 

You can simply ask a bank representative to explain their calculations or use a savings or mortgage calculator online, but knowing about the types of interest banks or other institutions use can be helpful. For instance, if you want to choose a savings account or term deposit that can rapidly grow your savings, you should know that accounts offering compound interest may be more helpful than those offering simple interest. 

How are the different types of interest calculated?

The interest on a financial product may be calculated using simple interest or compound interest, although in some cases, the institution may calculate the annualised or effective annual rate if the interest is applied for less than a year. 

As the name suggests, simple interest is calculated only on the principal amount, such as a savings account deposit, using the following formula:

Interest = principal x interest rate x term duration

Note that the interest rate is usually expressed as a per-annum percentage, and you may need to either calculate the daily or monthly rate or ensure you calculate the duration in years as well.

Compound interest is sometimes called interest on interest as the interest is calculated on the total of the principal and the interest earned or accrued earlier. Suppose your savings account provider offers you six per cent interest per annum, but the interest is compounded every quarter. If you deposited $1,000 at the start of the year, you’d earn $15 in interest at the end of the first quarter, and a total of $61.36 over the year. Note that the effective annual interest rate is 6.136 per cent, which would be the annual rate if you compounded the interest annually instead of quarterly. 

How can choosing the type of interest help me grow my savings faster?

In simple terms, the more frequently your savings account earns interest, the faster you can grow your savings. However, the assumption here is that you do not withdraw any money from your savings account, whether the deposit or the interest. 

If the interest on your savings account deposit is compounded quarterly, but you withdraw the interest as soon as you earn it, at the end of the year you would have the same account balance as you would if the account offered simple interest. In effect, you would lose out on the benefit of compounding the interest, which would grow worse if you withdrew even more from the account.

To take full advantage of compound interest, you may want to plan on making periodic deposits, no matter how small. For instance, if you deposit $100 at the beginning of each month after opening your account with $1,000, an interest rate of six per cent compounded quarterly would yield $100.91 in interest in one year, compared to $61.36 if you didn’t make the $100 monthly deposits. 

Continuing the deposits for a long duration while restricting the withdrawals from the account would ensure faster growth of your savings. You could compare different products to find one that offers a higher interest rate and more frequent compounding of the interest, as that would increase the annualised interest rate even further. 

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