Let’s Break it Down: Simple, Unearned + Compound Interest

So, you’re looking into taking out a loan or starting some kind of savings plan, but you've hit a snag when it comes to all of the interest talk. We understand. It can be little boring and very confusing.

Here’s a quick breakdown on the types of interests you’ll likely be faced with at one point or another – what they are, how they’re calculated, and what that means for you and your money matters.

Simple Interest

What It Is: Simple Interest earns its name based on the “simplicity” that comes with calculating it over other types of interest – as it ignores the effects of compounding. When it comes to simple interest, the interest charge will always be based on the original principal – so that 'interest on interest' is not included.

How It’s Calculated: To calculate Simple Interest, you’ll multiply the principal by the interest rate by the number of periods to determine the interest charge: P x I x N That is:

Loan Amount  x  Interest Rate  x  Duration of the Loan (or Number of Periods)

What It Means for You: You’ll most commonly come across simple interest when dealing with short-term loans. Simple Interest is common – and in addition, it’s easy to calculate and keep track of.

Compound Interest

What It Is: Another way to think of Compound Interest is “interest on interest.” Because this interest is calculated on the initial principal and also on the accumulated interest, it will cause a deposit or a loan to grow at a faster rate than Simple Interest. The rate at which Compound Interest accrues depends on the frequency of compounding – so, the higher the number of compounding periods, the larger the amount of compound interest will be.

How It’s Calculated: To calculate Compound Interest, you’ll take the total amount of principal and interest in future (or future value) minus the principle amount at present That is:

= [P (1 + i)ⁿ] – P

= P [(1+i)ⁿ – 1]

Where P = Principal, i = nominal annual interest rate in percentage terms, and n = number of compounding periods.

What It Means for You: Compound Interest is something you want when it comes to savings and deposits – especially retirement savings - as they’ll grow much more quickly. But it’s not so great when it comes to loans – as the amount of interest you owe will add up fast.

Unearned Interest

What it Is: Unearned Interest is also referred to as an “unearned discount.” That’s because this interest has been collected on a loan by a lending institution, but has not yet been counted as income, or earnings (for them.) Rather, it is initially recorded as a liability and if the loan is paid off early, then the unearned interest portion must be returned to the borrower (that’s you!)

How It’s Calculated: Unearned Interest is calculated using an equation based on the Actuarial Method. Sounds scary, right? Have no fear! There are many interactive online calculators available (like this one) that use the Actuarial Method – or Rule of 78 – to determine Unearned Interest for you.

What It Means for You: You’ll come across Unearned Interest most often when it comes to long-term, fixed-income securities. The interest that you would owe on the loan is forgiven by paying off the loan early. For example, if you take out a car loan and agree to pay the loan off in 60 months, but end up paying it off after 48, you’ll save that much in interest.

Source: Investopedia