# What is Interest?

## Overview

Interest is not earned by holding a share but you do receive interest depending on what type of account you have on the cash balance of your investment.

This module will help to answer questions around the topic of interest in finance.

Simple vs Compound Interest

Interest is the cost of borrowing money, where the borrower pays a fee to the lender for using the latter's money.

There are two ways in which interest can be calculated, simple interest or compound interest.

- Simple interest is worked out on the principal, or original, amount of a loan.
- Compound interest is calculated on the principal (original) amount and also on the added interest of previous periods, and so can be seen as “interest on interest.”

There can be a vast difference in the amount of interest to be paid on a loan if interest is calculated on a compound rather than simple basis. On the upside, the magic of compounding can be advantageous to you when it comes to your investments and can be a potent factor in wealth creation.

Although simple and compound interest are basic financial concepts, it may be of assistance to you to become fully familiar with them in order to make informed decisions when taking out a loan or investing.

Simple Interest Formula

The formula for calculating simple interest is:

Simple interest = P x i x n

where:

P = Principle

i = interest rate

n = term of the loan

As a result, if simple interest is charged at 5% on a R10,000 loan that is taken out for three years, the total amount of interest payable by the borrower is calculated as:

R10,000 x 0.05 x 3 = R1,500.

Interest on this loan is payable at R500 per year, or R1,500 over the three-year loan term.

## Compound Interest Formula

The method used to calculate compound interest in a year is:

Compound interest = [P(1+i)ⁿ] − P

Compound interest = P[(1+i)ⁿ − 1]

where:

P = Principle

i = interest rate in percentage terms

n = number of compounding periods for one year

Compound Interest = Total amount of Principal and Interest in the future (or Future Value) less the Principal amount at present called Present Value (PV). PV is the present worth of a future amount of money or stream of cash flows given a definite rate of return. Carrying on with the simple interest example, what would the interest amount be if it is charged on a compound basis? In this case, it would be:

R10,000 [(1 + 0.05)³ – 1] = R10,000 [1.157625 – 1] = R1,576.25

While the total interest payable over the 3-year period of this loan is R1,576.25, unlike simple interest, the interest amount is not the same for all 3 years because compound interest also takes into consideration collected interest of previous periods.

## Time Value of Money

Time value of money is the financial term to describe how money can earn interest or grow over time. No matter who you are, "cash is king" and money now is worth more than money received later because it can earn you interest over time.

In simple terms, compounding is about earning something, like a dividend, and then reinvesting this income which will then also earn income and then reinvesting this income too.

Thus, the process continues into great returns and your money starts working even harder for you. The key point to bear in mind here is the long term focus, as this is where it starts to show up in its exponential form.

It is important to note that interest is not earned when buying shares. You can earn interest on the cash balance sitting in your broker account, depending on whom you have an account with.

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