Simple v Compound Interest

There are two ways to calculate interest: Simple and compound.

To calculate simple interest, multiply the interest rate by the loan amount by number of periods. It is important in this computation to keep all the units of measure consistent. For example, if a loan has a 12.0% per year interest rate but you want to know the amount of interest paid in a month, you would need to divide the annual rate of interest by 12 to get a monthly rate of interest.

When you take a loan out though, you will not be paying simple interest. All major UK lenders charge compound interest on the money they lend. Simple interest only calculates an amount of interest based on the principle the amount borrowed (often called the principle). Compound interest charges you on both the principle as well as any unpaid interest. This is a more sophisticated calculation.

To demonstrate the difference between simple and compound interest, take an example of a £1,000 loan for 2 years with an interest rate of 10% per year. If you were to repay this loan at the end of the two in one payment, you would owe £1,200 if you calculated the interest using simple interest. This is calculated:

Year One: £1,000 x 1 year x 10% =	£100
Year Two: £1,000 x 1 year x 10% =	£100
Total Interest paid:	£200
Principle Repaid:	£1,000
Total Payment at the End of Year Two:	£1,200

If the interest compounded annually, you would owe £1,121:

Year One: £1,000 x 1 year x 10% =	£100
Year Two: £1,000 x 1 year x 10% =	£110
Total Interest paid:	£210
Principle Repaid:	£1,000
Total Payment at the End of Year Two:	£1,210

Notice how with compound interest, in the second year you pay interest on your interest but with simple interest you only pay interest on your principle.

This example is an obvious oversimplification because normally you are repaying the loan at the same time you are being charged interest. In fact, most personal loans offer you a flat monthly payments but the amount of interest and principle being repaid by the payment will change over the course of the loan. In the beginning, most of the monthly payment will be used to repay interest and only a small portion of it will be applied to the principle of the loan. As time goes on, the proportion of the monthly payment which goes towards paying interest will decrease and the amount towards repaying principle will increase.

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