You have probably come across terms like “simple interest” and “compound interest” before. So you are probably aware that these terms exist, but you might not be entirely clear on what they mean. In this article, we will try to explain these terms to you, and we will also show you how to calculate interest under compound interest.
What is interest calculation?
Interest calculation is the method used to work out interest. We divide it into simple and compound.
Simple interest is a method of calculating interest where, at the end of each interest period, the interest is calculated on the original capital. The most common interest period is a year or a month. However, you might also come across daily or weekly interest.
Let’s look at an example.
At the start of 2023, you deposit 5,000 USD into an account with 5% interest per year. You deposit this money for a period of 5 years. The bank uses simple interest (we will ignore tax on interest for now). How much will you be withdrawing from the account after 5 years?
5% of 5,000 USD is 250 USD. So at the end of each year, 250 USD is added to the original amount. At the end of the first year, you will therefore have 5,250 USD in your account, at the end of the second year it will be 5,500 USD, and at the end of the fifth year this amount will be 6,250 USD.
Put simply, simple interest is therefore an increase of the original deposited amount by only the stated interest. This type of interest calculation is used, for example, for savings periods shorter than 1 year.
Compound interest
Compound interest is a little more complicated than simple interest, but only in terms of the calculation.
However, this way of saving money is much more sought-after, and also more advantageous. Why? It is fairly simple, with compound interest, interest is also calculated on interest. This means that interest is calculated not only on the invested capital, but also on previous interest that was already credited in the past.
You could say that your money works for you.
How does compound interest work?
Let’s look at an example.
Let’s say you deposit 5,000 USD in the bank for a period of 5 years, again with interest of 5% per year. After the first year, you have 5,250 USD in your account. In the second year, though, the interest is already calculated on the amount of 5,250 USD. So after the second year, you have 5,512.50 USD in your account, and after the third year this amount is 5,788.13 USD. After five years, you will therefore have 6,381.41 USD in your account. That is 131.41 USD more than you would have under the same conditions with simple interest.
This amount is therefore higher the longer you invest in products that offer compound interest. So when investing, it is not so much the amount you invest that matters, as the regularity and the length of time over which you grow your money.
Why is compound interest much more advantageous than simple interest?
As we already showed in the example above, not only will compound interest leave you with more money (imagine, too, what a difference this will be compared with simple interest, if you save for 40 years instead of 5 and contribute to a savings account every month), it is also better for fighting inflation, which is the killer of savings.
If you would like to find out more about what inflation is and the best way to grow your money, take a look at this article too.
Which banking products offer compound interest?
The safest choice for compound interest is a savings account. Nowadays it typically yields around 5% a year, but the interest is often added each month.
Other products that use this type of interest include, for example, term deposits or building savings (stavební spoření).
These methods, however, are among the more conservative ones. A more dynamic way of potentially growing your money is investing. If you would like to find out more about this topic, this article about the top investing books might help you. If you already have some investing experience, take a look at these tips on how to build your ideal investment portfolio.
If you would like to calculate for yourself how much you could reach under different conditions, take a look at this calculator for savings, where you just enter the key parameters and it will tell you how much money you could have from saving over 5, 10 or 15 years.