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