Plants need sunlight and water to grow, right? Well, your investment needs its own 'sunlight and water' to grow too. This is also known as interest. But here's the thing – not all interest works the same way.

There are a couple of types of interest you may have heard about at some point along your investing journey – simple interest and compound interest. We've already covered the first in the ' What is compound interest? ' article, so we'll focus on simple interest for this one.

Let's unpack this basic, yet crucial concept in investing. Think of simple interest as the ABC of how your money grows over time. By the end of this article, you'll not only understand what simple interest is, but also how it affects your investment choices.

So, are you ready to learn more and see your investments grow, just like that little plant sitting by your window?

What is simple interest?

Simple interest is important to understand, whether you're investing, getting a personal loan, or applying for a mortgage. Knowing about simple interest is like having a secret key – it helps you work out exactly what you'll earn or owe.

So, what's simple interest? It involves three key components: the principal, the interest rate, and the time period.

1. Principal: This is your starting amount. It's the money you either invest or borrow.
2. Interest rate: This is a percentage that tells you how much extra you'll earn or pay on your principal. It's often shown as an annual percentage rate (APR).
3. Time period: This is the length of time your money is invested or borrowed.

The formula to calculate simple interest is a straightforward method: Interest = Principal × Interest rate × Time period. Note that in this formula, the interest rate is in decimal form, and the time period is the time in years. Just multiply these together, and you get your simple interest. Simple, right?

When it comes to investing, simple interest can show you how your money will grow over a set period. It’s a simple calculation, making it easier for you to compare different investment or loan options.

In a nutshell, simple interest is a key part of personal finance and can help you make better decisions when borrowing or investing money.

How is simple interest different from compound interest?

Not all interest is the same. A common mix-up in the world of investing is the difference between simple interest and compound interest.

With simple interest, you're earning (or paying) the same amount of interest each year, based on your original amount. This doesn't change, no matter how much your investment grows or loan principal reduces.

Now, compound interest is different. With this type of interest, you earn interest not just on your principal but also on the interest you've already earned. It's calculated regularly – yearly, monthly, or even daily. This means the total you owe (if interest due isn't paid) or earn grows over time – like a snowball getting bigger as it rolls down a hill.

Not knowing the difference between simple and compound interest can have a big financial impact. For example, if you're looking at savings accounts, retirement funds, or long-term investments, compound interest can boost your total funds. As an easy point of reference, banks can pay customers compound interest for their deposits.

For short-term loans, simple interest might be easier to manage since the amount you owe stays constant. But for long-term investments, compound interest can significantly increase your returns.

Simple interest example: Maya's term deposit

Maya chooses a term deposit that offers a 5% annual percentage rate (APR). This means Maya's interest is calculated only on the original $1,000 she puts in – that’s the principal.

Using the formula for simple interest (Interest = Principal x Rate x Time), after one year, Maya earns $50 (which is $1,000 x 5% x 1 year).

If Maya keeps her money in for another year, she'll earn another $50. The amount she earns each year stays the same because it’s always calculated on the original $1,000 invested.

Omar's compound interest journey

Omar, on the other hand, goes for a typical savings account that applies the same 5% rate but uses compound interest.

After the first year, Omar also earns $50. But in the second year, the interest is calculated on $1,050 (the original $1,000 plus the $50 interest from the first year).

This means Omar earns $52.50 in the second year (5% of $1,050). Over time, Omar's total grows more because the interest is calculated on a growing total.

Understanding this difference is key, especially when you compare small differences in rates or terms from different lenders or investment options. It helps you make smarter decisions about where to put your money, whether you're borrowing (like getting a personal loan) or investing.

What factors influence the simple interest rate?

Now we know how simple interest is calculated, but how are simple interest rates determined? There are several factors that influence a simple interest rate:

1. Economic strength: This is the overall health of a country's economy. When the economy is strong, people and businesses borrow more, so banks might raise interest rates. But if the economy is weak, they might lower rates to encourage people to borrow and spend.
2. Inflation : This is the rate at which prices for goods you buy (like food or clothes) increase. If inflation is high, lenders might increase interest rates. Why? Because they want to make sure the money they get back has the same buying power as when they lent it out.
3. Government policy: The RBA (Reserve Bank of Australia – Australia's central bank) has tools to control how much money is in the economy. They can change policies to either encourage spending or saving. These policy changes can directly affect interest rates. It's like adjusting the thermostat to control the temperature in your house.
4. Demand for loans: This follows the law of supply and demand. If a lot of people want to borrow money, banks might hike up the interest rates. But if fewer people are borrowing, they might lower rates to attract more customers.
5. Global financial market: Our world is highly connected. What happens in other countries can affect interest rates at home. If global markets are unstable, lenders might adjust interest rates in response.

Understanding these factors helps you see why simple interest rates change over time. So, when you're about to borrow money or invest, take a moment to consider these factors. They give you a clearer picture of what's happening with interest rates, thereby helping you to make more informed financial decisions.

What are some pros and cons of simple interest in investing?

In the world of finance, simple interest has its own merits. But for investing, it's important to understand that for certain investment goals, simple interest might not always be the best fit. So, let's get into some pros and cons of simple interest in investing.

Pros of simple interest in investing

1. Easy to understand and calculate: Simple interest is straightforward. You can quickly figure out how much interest you'll earn or owe using the formula. This simplicity makes it easier for you to plan and manage your finances.
2. Predictability: With simple interest, what you earn or owe remains constant over time. It's calculated on the original amount you invest or borrow (the principal), so there are no surprises. This predictability can be great for short-term loans, where you want to know exactly what's happening with your money.
3. Less risky for short-term loans: If you're borrowing money for a short period, simple interest can be less risky compared to compound interest. Since the interest doesn't increase over time, you won’t owe a growing total.
4. Clear impact on return on investments: For investments, simple interest provides a clear, fixed return. You know exactly how much you'll earn over the investment period, which can help in making informed decisions, especially if you're comparing different investment options.
5. Beneficial for savings and certain investments: For certain types of savings accounts or investments, like bonds or certificates of deposit, simple interest can work well. You get a steady, predictable return without the complexity of compound interest calculations.

Cons of simple investing

1. Lower returns over long periods: Simple interest is calculated on the original amount (the principal) only. This means that over a long period, your investment might earn less compared to compound interest, where the interest is calculated on the growing total (the principal plus earned interest).
2. Not ideal for long-term investing: If your goal is to grow your savings significantly over many years, simple interest might not be the best option. Since it doesn't take into account the interest you've already earned, the overall growth of your investment could be slower compared to using compound interest.
3. Less beneficial for savings: When it comes to saving money, simple interest might not be as rewarding as compound interest. With compound interest, your savings have the potential to grow faster because you earn interest on both the money you put in and the interest that accumulates over time.
4. Limited impact in a rising interest rate environment: If interest rates go up, the return on investments or savings using simple interest doesn't increase since it's fixed on the initial principal. This could mean missing out on potential gains that you might get with compound interest in a similar scenario.
5. Not as competitive for loans and investments: When you're comparing loan or investment options, simple interest might not always offer the best deal. For instance, some lenders or investment platforms might offer compound interest, which could provide better returns or more competitive loan terms.

While simple interest is straightforward and predictable, it might not always align with your financial goals, especially if you're looking to grow your investments significantly over time.

Investors often feel uncertain because they need to figure out which type of interest aligns with their goals. It's about comparing and seeing which one makes your money work best for you.

Investment strategies (simple vs compound interest)

One common question for investors is which investment strategy to pick. There are so many, and it can be tough to know which one is right for you.

Using an investment strategy suitable for your goals is key to your financial growth. It's like having the correct map for a journey. It guides you to your destination, which in this case is your financial goal.

What investments use simple interest?

Before we look at investment strategies, let's dive into the types of investments that use simple interest. Here are some common investments that apply a simple interest rate:

1. Bonds: bond , you're lending money to the government or a company. They agree to pay you back the full amount later, plus a simple interest amount.
2. Certificates of deposit (CDs): These are a special kind of savings account. You agree to leave your money in the bank for a fixed period, and in return, the bank pays you interest. The interest on CDs is usually calculated using simple interest, so you know exactly how much you'll earn.
3. Some savings accounts: While many savings accounts use compound interest, there are still some that use simple interest. With these accounts, you earn interest just on your principal, and that rate remains constant.
4. Treasury bills: These are short-term government securities You buy them for less than their face value and get paid the full amount when they mature. The interest you earn is, in essence, the difference between what you paid and what you get at maturity, calculated using simple interest.

Understanding where simple interest applies in the investing world can be useful. It helps you make decisions about where to put your money, especially if you prefer investments where you can easily calculate and predict your returns.

What if I want to avoid simple interest and seek compound interest?

Simple interest is straightforward. But with compound interest, it's like your investment is doing extra work for you. Over time, this can add up and make a big difference to your investment earnings.

So, how do you find these compound interest opportunities? Here are some tips:

1. Look for investments using compound interest: Many banks offer simple investments like savings accounts that apply a compound interest rate on a monthly or even daily basis. This means you're earning interest on your interest regularly, which can grow your savings faster.
2. invest in mutual funds or ETFs : These investment products often reinvest dividends, which can lead to compounding. It’s a way to invest in a collection of stocks or bonds, and the dividends you earn get put back into your investment.
3. Read the fine print: Always check the details of any investment product. Look for terms like “compound interest” or “compounded annually.” Understanding the specifics can help you make better decisions.

Remember, while compound interest can lead to a growing total over time, it’s important to match your investment choices with your personal financial goals and risk tolerance. It’s not just about the potential for higher returns, but also about what feels right for you.

Which investing strategies use compound interest?

Strategies that use compound interest can act like a booster for your investments.

Many investment types use compound interest – stocks, ETFs, managed funds, property, high-interest savings accounts, and even superannuation. But there are a couple of key investment strategies you can use to take advantage of the benefits of compound interest. These strategies are:

1. Dividend Reinvestment Plans (DRPs) : When you invest in stocks, some companies pay dividends. Instead of taking this cash, you can reinvest it to buy more shares. More shares mean potential for more dividends, and reinvesting those can grow your investment over time by adding to your compound interest amount.
2. Buy and hold strategy : This is buying stocks or other investments and just holding onto them for a long time. The idea is that over the years, the value of these investments can go up. Plus, when any dividends or interest you earn gets reinvested, your money works even harder for you.

Using these strategies can help you maximise the power of compound interest. It's about patience and consistency. The longer you leave your money to grow and the more regularly you add to it, the more you can benefit from compound interest.

Final thoughts: simple interest simplified

Alright, let’s wrap this up! Hopefully by now, you have a clearer understanding of what simple interest is, how it differs from compound interest, and what factors influence it.

You now know the key components – the principal, rate, and time – and how to use the formula to calculate simple interest. We also explored how simple interest plays out in real world situations and the different investment strategies you can use if you prefer the impact of compound interest on your investments.

So, as you continue your financial journey, keep these insights in mind. They'll help you figure out when simple interest might work in your favour and when you might want to look for opportunities to earn compound interest. Remember, every step you take in learning about investing is a step towards a more secure financial future.

Happy investing!