Here’s a quick explanation on how to calculate the interest that you can earn on your savings (or pay on your debt).
Let’s use an example of R1,500 (don’t worry about the currency – the maths is the same) and you deposit it in your bank account that earns 3.5% interest.
First thing to note is that the interest rate is always given as the annual rate (unless very specifically detailed otherwise). If you use a calculator (or a spreadsheet such as Excel) and do the following : 1500 x 3.5% the answer you get is 52.50.
Thus R1,500 invested for 1 year at 3.5% interest will earn R52.50. That’s easy!
To calculate what the monthly interest is, simply divide 52.50 by 12 and you will get R4.38 (rounded up) interest for 1 month. You could be more accurate and divide 52.5 by 365.4 (number of days in the year) and then multiply by the exact number of days in the month (e.g. 30).
E.g. 52.5 divided 365.4 multiplied by 30 = R4.31 (a very slight difference to the first answer we received)
So, if you invest R1,500 for 1 year at an interest rate of 3.5%, the interest at the end of the year would be R52.50. However, banks and all financial institutions calculate interest on a daily basis and pay it out monthly. If you withdrew each months interest (and leave the original amount of money in the account) then you would effectively earn “simple” interest – just as we calculated above and you would have R52.50 (assuming no fees or charges)
However, if you leave the interest that you earn each month in your account, then the bank would calculate the next months interest on your original amount plus whatever extra interest is already in your account. So each month you would earn slightly more. This is what is called “compound” interest.
In this case the difference is not great, but the larger the starting amount is, and the longer time you keep reinvesting the interest, the larger the difference is! In fact, after a few years, compound interest can be really large. Remember of course that we are assuming that no fees or charges apply.
This example may seem simple, but there is no need to complicate things!
For a practical example of how to use this to calculate the interest on your home loan payment have a look here.