The different types of interest can be a bit confusing. We've put together some definitions to help you understand some of the differences.
If you deposit money in a bank, interest is the money that you earn, as a percentage of your deposit. If you owe money to a bank or a credit card company, interest is a percentage of your balance that you pay for the use of the bank or credit card company's money. It is typically shown as an annual percentage rate e.g. 6.00%pa (pa = "per annum", which means "each year").
Simple interest or nominal interest
When you earn simple or nominal interest in a bank account, it is paid only on the money that you have deposited into your account, and not on your account's earnings (interest payments). There are no benefits of compounding your earnings,
When you earn 6.00%pa interest on $10,000 that you have in a bank account, this means you get paid $600 per annum interest.
When your money earns compound interest in a bank account, the interest earned is added to your balance on a regular basis. So not only does your money earn interest, your interest earns interest too. It will be shown as an annual percentage rate e.g. 6.00%pa.
Let's say the interest rate on an account is 6.00%pa and it is paid monthly. You invest $10,000 on 1 January and do not intend to add any more money to the account. At the end of the first month you'll have earned interest of $50.96 for the 31 days. Therefore, for the month of February, interest will be calculated on $10,050.96 for 28 days. By the end of the year, your total balance will be $10,616.78.
Our Savings Maximiser compounds interest each month which is a great benefit to your savings!
Effective annual interest
If you have a simple or nominal interest rate for a period of less than one year, you can calculate an effective annual interest rate by compounding the interest earned.
You open a Term Deposit for 3 months for $10,000 at a rate of 6.70%pa. To get the effective annual rate, you assume that the interest will be compounded every 3 months (i.e. add the interest to your initial investment and reinvest at the same rate for another 3 months), with the resulting effective interest rate being 6.87%pa.