Simple or compound interest – when and how to use them

As we approach the end of the year, while you are lounging on a beach or in the bush, your thoughts may turn to building on your wealth for next year. There are always many decisions to be made, as wealth creation can be a complex business. Fortunately, you have Financial Advisors to turn to in this regard, but it is also useful to know as much as you can because good FAs will always work in partnership with you.

An interest in interest

As we all know, when it comes to maximising savings interest is what it is all about. The interest you earn and the rate at which you earn it can make the difference between your savings being eroded quite rapidly or growing exponentially.

As with most things relating to finance, there is never just one option. There are different types of interest, and we thought it may be of interest to you to explore this a little further. So, let’s look at the differences between simple and compound interest – and when and how to use them.

Simple interest

Simple interest grows based only on the money you deposit or invest (the principal amount). The Investopedia definition is ‘’an interest charge that borrowers pay lenders for a loan. It is calculated using the principal only and does not include compound interest.’’

So it’s typically the type of interest that banks pay customers on their savings accounts. To calculate it, you just multiply the loan’s principal amount by the annual interest rate by the term of the loan in years.
A typical example of when simple interest is applied would be with a Fixed Term Deposit which is when you invest a fixed amount for a fixed duration (usually 2 to 60 months), with a fixed interest rate. Because all the variables are fixed, you get a guaranteed growth rate.

Compound interest

We have written many times about the magic of compound interest and this, because you earn interest on the interest you reinvest, is certainly the investor’s best friend. There are simply no limits to how great interest earnings can be as it is entirely dependent on how long you keep the capital amount, plus all interest earned on it, reinvested.

An Income Fund is a good option for investors considering investing in a fixed-term deposit with more flexibility. Unlike fixed deposits which come with a fixed lock-in period, you can withdraw money at any time. It offers liquidity and capital appreciation, and its returns are strong because it benefits from the aforementioned compounding interest.

What is best for you?

The bottom line is which is better for you, simple or compound Interest? Well, compound interest is the better choice if you’re saving money in an account or being repaid on a loan. If you’re borrowing money, however, simple interest is the better choice as you’ll pay less over a period of time.

The best choice always though is to consult with a qualified Financial Advisor in Hereford Group who, apart from being highly skilled as an investment advisor, is also trained to understand that all people are unique and will advise you according to your specific circumstances.

Whatever your aspirations for 2024 may be, this is a great time to revisit your portfolio with your advisor and if you are going to travel these holidays, please do ensure that you have accident, and income protection cover in place as well as an up-to-date Will and a good Life insurance policy.

Talk to us – we are always here to help – and happy holidays!


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