Compound interest is really not a difficult concept and understanding it can save you – and even make you – money!

Compound interest describes the process of charging – or earning – interest on interest. The former is not so good; the latter is great. So, whether you are borrowing money or investing it, the concept is the same. What happens is that interest earned on a loan or investment is added to the original amount. The interest payable is regularly recalculated on the original amount and also any previous interest earned.  When financial whizzes speak of compounding, this is what they mean.

What is the difference between compound and simple interest?

The opposite of compound interest is simple interest. This builds only on the original amount, while compound interest builds on both the principal sum and the previously earned interest. Because of this, compared to simple interest, compound interest always gives greater profits on an investment or higher expenses on a loan – and this is where you can save money. Unless simple interest is expressly stated, you must assume that interest is compounded.

Look at the numbers. 3% simple interest calculated on a R20,000 investment earns R3,000 over a period of five years. If the same investment receives compound interest, it yields a R3,185.48 return after five years. Okay, so that’s a small amount but over time  it adds up and makes a bigger difference on a bigger amount – especially when it’s calculated on a loan and you’re the one paying it!

How often is interest compounded?

The periods used to calculate compound interest vary and are determined according to the terms of each individual investment or loan. The more frequent the periods are, the faster an investment or loan grows. For example, if compounded twice annually, 7% interest applied to a R50,000 investment earns R36,699.30 in interest after eight years. If the same investment is compounded monthly, it earns R37,391.32 after eight years.

Negotiating interest rates

Aside from asking for higher or lower interest rates, on an investment or loan respectively, one of the best ways to negotiate is to talk smart with loan providers and investment managers about the way your interest is calculated. Ask loan providers to compound interest less frequently on a loan or, better yet, ask for simple interest. And ask for compounded interest on your investments, the more frequently the better. You’ve got nothing to lose and everything to gain.