Compound interest – not as complex as it sounds!

Understanding the basics of compound interest can be very important in helping you increase your control over your family budget and finances. That's because both savings and borrowings constitute a large part of many families' month-to-month budgeting and this type of interest has a large affect on both of those things.

Why does this matter?

Put bluntly, it matters because compound interest affects how much you'll be paying for borrowed money or conversely, how much someone will be paying you to deposit your money with them. It also directly affects how easy or hard it will be for you to compare one deal for borrowing or savings against another.

Let's take the example of a loan where you've borrowed £1000 for a year and the interest is 1.2% interest per month. In this example we have assumed that the loan would be paid back at the end of the year in one payment.

You may be tempted to work out how much how much this is going to cost by multiplying your £1000 borrowing by 1.2% per month giving a total repayment figure of £1144, or 14.4% yearly interest (12 months x 1.2% = 14.4%).

Sadly, for compound interest this is wrong because it doesn't take into account the fact that the interest is accumulating each month through the year. In fact, for this example loan, after 12 months you will need to pay back in total approximately £1154.

The compounding interest each month means that over the year, you'll end up paying a total of 15.39% interest overall on the original £1000.

The actual calculations behind that are a little complicated but the good news is that on the Internet you can find many examples of free compounding interest calculators that will help you work out exactly what the figures are in your specific case.

Exactly the same principles would apply if you were looking to open a savings account. Compound interest would be working in your favour this time because you'd be getting interest paid to you that was based upon previous interest already credited to your savings pot.

Compound interest & APR

Many loan companies, particularly the credit card companies, often advertise their products in terms of monthly interest rates. They do this because 1.2% sounds so much more reasonable and cheaper than 15.39%!

The government decided a long time ago to try and help families understand just how much a loan was really going to cost (or savings generate) by insisting that banks and finance companies publish the total or Annual Percentage Rate (APR), though this is also sometimes called the AER just to confuse people.

In the above example, the APR would be 15.39% and it should be stated on most loan offers, as should the total repayment amount. Sometimes the APR is buried somewhere in the small print of a loan advertisement though most reputable lenders will highlight them to make it clear to you.

In the case of savings, most organisations by contrast widely proclaim their APR. All other things being equal, the higher the APR offered by a savings product then the more interest you'll receive on your money.

It may be worth keeping in mind though that APR isn't necessarily the only thing you need to stay in control of in terms of where to save your money. It's worth also making sure that the savings product is going to give you what you want in areas such as:

• Access to your funds – some savings only offer a guaranteed higher APR if you leave them untouched for a specified (and perhaps lengthy) period of time
• Withdrawals – some accounts may offer a higher APR but only if you give say 3 months notice of your intention to take money out

There are quite a few possible variations on these themes where savings are concerned. Checking the small print is usually a good idea.

As a general rule, if you are borrowing you'll want to find the lower APRs. When you're saving, you obviously want the highest APR you can find!

Using APRs and compounding interest in the family budget

Compound interest and the APR are important tools for you to use in managing your budgets because:

• You can shop around for the best deals on borrowing or saving (tip – be wary of lenders that tell you the APR isn't really important because they offer 'insurance included' or 'free months' etc)
• They indicate that the longer period you borrow over, the more expensive your loan becomes in real terms even if the individual monthly repayments are reduced
• It may give you the opportunity to move your money around and get a better use out of your savings etc

For example, if you have some money in savings earning interest at 5% APR but a loan where you're paying interest at 9.5% APR, then you may decide that it would be better to take your savings and pay off that loan early assuming you have sufficient money in the account. Your family budget may be better off overall by a significant sum.

Alternatively, you may be able to find a savings account that's offering a much better APR than you're currently getting. In such cases you may be able to close your existing account and move your money to the new account and generate a better return on your savings.

So compound interest can be something that you can use to your advantage in many different ways.