Facts

Compound interest explained

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When borrowing money, the term ‘compound interest’ can be thrown around, but what does it mean?

In simple terms, compound interest is interest added onto an amount that you’ve borrowed or saved, plus interest on top of that. Here, we’ll explain what that means.

Firstly, don’t be confused by compound interest as simple interest. To tell the difference, just look at the name. Simple interest is simple. Simple interest is only based on the principal amount of a loan. So, for example, if you take out a loan of AED 18,000 and the annual interest rate on the loan is 6%, and if it takes you three years to pay back the loan, the simple interest added onto the loan would be AED 3,240 (AED 18,000 x 0.06 x 3).

But interest works completely different when it’s compounded.

If you take out a loan that uses compound interest, the longer you borrow for, the quicker the debt will grow. Not only do you need to pay back the money you’ve borrowed, but you also pay the interest on the interest that has grown over the loan period. So, for example, if you take out a loan of AED 10,000 with an annual interest rate of 10%, then in the first year you would gain AED 1,000 in interest (AED 10,000 x 0.10), which is then added onto the initial loan, AED 11,000. The following year, if you still haven’t managed to make any payments, then the added interest would be calculated as AED 11,000 x 0.10 = AED 1,100 in interest. So, by year two, you would owe AED 12,100 (AED 11,000 + AED 1,100) and so it goes on each year.

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How are you supposed to know if the loan you are taking out offers simple or compound interest? One simple method to determine if your loan uses simple interest or compound interest is to compare its interest rate against the debt-burden ratio. If there is a substantial difference between the debt-burden ratio to the interest rate, then your loan is most likely using compound interest. All banks are required though to disclose to lenders the terms of a loan, including the total amount of interest that should be repaid over the life of the loan.

Compound interest is also common when it comes to credit cards, and this is when compound interest is not your friend. Credit cards usually add interest daily, so that would mean interest is added to the interest already accrued each day, in-between your monthly payments. Although most cards can offer up to 56-day interest-free period in which you can pay off your bill in full, if you don’t manage too, then the interest will amount quickly.

So, let’s try and break this down for you.

Most UAE credit cards carry an interest rate of 2.83% per month, so if you have a revolving balance of AED 10,000 on your credit card and the daily interest is 0.094% (2.83 % ÷ 30) then on the first day you will need to pay AED 9.40 in interest (AED 10,000 x 0.00094) so, on the second day, interest will be calculated with your new balance, AED 10,009.40. And the balance will keep on compounding until you have paid it off.

The idea of interest being added daily can be daunting. Especially when there can be such flexibility of choosing how much you pay off each month. So, what can you do to try and avoid drowning in debt before it’s too late? It’s advised that you should try and pay off more than the minimum amount each month, because otherwise you are likely not paying off any debt, just the added interest that has accumulated. And that’s when it turns into a viscous cycle.

Another thing to look out for is how often the interest is being compounded. Compounding interest can occur semi-annually, quarterly or monthly. Obviously, if the loan is compounded more frequently, then that means the rate at which the interest is calculated increases – like with credit cards.

It’s all seemed pretty negative so far, but never fear. There can be huge benefits if you use compound interest to your advantage. The only time you would want to see compound interest is if you are saving money. We all like the thought of earning interest on our savings. And if you end up putting money away each month and decide to add to it and save it for years, then compound interest can be your best friend.

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Compound interest can work in your favour if you save or invest your money well. However, it’s not really a case of seeing the benefits sooner rather than later; it’s the other way around. Building up your money on compound interest could take years before you really see a difference. If you put aside AED 5,000 every month with an annual interest rate of 0.85%, at the end of each month your interest rate will be 0.0708%. So, after the month you have earned AED 3.54 (AED 5,000 x 0.00708). Compound interest will then be calculated each month on the interest earnings as well as your principal. It may not seem like a lot, but as explained earlier, it turns beneficial the longer you leave it.

Compound interest doesn’t have to be as daunting as it seems. Using it to your advantage rather than letting it take over your money situation yields great benefits for money-minded people.

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