When it comes to borrowing and saving decisions, it's crucial to make sure that you understand the various financial tools at your disposal so that you can make informed decisions and optimise your finances.
For example, when taking out a business loan, the total interest that you end up paying on the debt will often be quite different depending on whether it’s calculated using APR or using a flat rate. It’s important to properly understand the differences between these terms so that you can take out the right loan option for your business.
Similarly, when it comes to earning a return on your savings, it’s important to understand which saving accounts are going to end up paying you back the highest return, and it’s not always as simple as just looking at who offers the highest interest rate today.
In fact, one of the most simple, effective and powerful ways to build your savings over time is to ensure that you properly utilise the power of compounding interest. Despite this, it’s still common for people today to undervalue how powerful compound interest can be.
In this article, we’ll look at each of these points, first focusing on the interest that you pay on a loan and the distinctions between APR and flat rate loans, before discussing compounding interest and the impact it can have on your savings.
APR vs. Flat Rate Loans: Key Differences
When considering a loan, it’s essential to understand the differences between APR (Annual Percentage Rate) and flat rate loans, as each has unique characteristics that can affect your overall borrowing cost and the way that your debt changes over time.
APR (Annual Percentage Rate)
APR, or Annual Percentage Rate, represents the total cost of borrowing, encompassing both interest and any associated fees.
The calculation of APR incorporates the interest percentage on the borrowed amount along with additional fees. For instance, a 5% APR loan might comprise 4% interest and a 1% arrangement fee.
This rate is applied to the outstanding balance throughout the loan term, meaning interest is calculated solely on the remaining loan amount as you repay it. APR is generally more transparent, reflecting the actual cost of borrowing over the loan’s lifetime.
It’s also important to note that in the UK, issuing loans with an APR is a legal requirement, ensuring borrowers have a clear understanding of the total borrowing cost.
Flat Rate Loans
In contrast, flat rate loans involve a consistent charge of interest on the entire initial borrowed amount throughout the loan term.
The interest rate is applied to the full loan amount without accounting for repayments. For example, if you borrow £10,000 at a 2% interest rate, you would pay 2% on the full £10,000 each year.
While flat rates might initially appear cheaper due to the lower annual interest rate compared to APR, they do not consider the repayments made over the loan term (i.e. even when you’ve paid off most of the loan, you’ll still be paying 2% of £10,000 in interest). Flat rates are less common and generally less transparent, making it crucial to verify if you’re quoted an annual rate.
Over the loan’s lifetime, flat rate interest payments can end up being more expensive than those calculated with APR.
In Summary
While a fixed rate loan might look like better value at first glance, if you value transparency and want an accurate representation of your borrowing costs, opting for APR is the better choice.
The Power of Compound Interest on Savings
Compound interest can significantly boost the growth of your savings over time. When you deposit money into a savings account that offers compound interest, the interest earned on the principal amount is periodically added back to the principal. This results in interest being earned on the new, larger balance in subsequent periods.
The effect is cumulative, meaning the longer the money is left to grow, the more exponential the growth becomes. This compounding effect accelerates the growth of your savings, making it a powerful tool for achieving long-term financial goals. The longer you’re able to leave the savings to compound, the more dramatic the annual payments will become, until before you know it, you’re on a completely different level vs where you started..
People often are amazed to see just how effective compounding can become, perhaps because it’s more difficult to visualise compounding growth in your mind compared to standard linear growth. What is clear however is that if you want to make the most out of your savings and build substantial wealth over time, it’s crucial to leverage compound interest.
To show you an example, lets consider a £5 million deposit in a savings account with an annual compound interest rate of 5.05%. Over five years, the savings would grow as follows:
Year 1:
Principal: £5,000,000
Interest: £5,000,000 * 0.0505 = £252,500
New Balance: £5,000,000 + £252,500 = £5,252,500
Year 2:
Principal: £5,252,500
Interest: £5,252,500 * 0.0505 = £265,253.13
New Balance: £5,252,500 + £265,253.13 = £5,517,753.13
Year 3:
Principal: £5,517,753.13
Interest: £5,517,753.13 * 0.0505 = £278,658.49
New Balance: £5,517,753.13 + £278,658.49 = £5,796,411.62
Year 4:
Principal: £5,796,411.62
Interest: £5,796,411.62 * 0.0505 = £292,720.77
New Balance: £5,796,411.62 + £292,720.77 = £6,089,132.39
Year 5:
Principal: £6,089,132.39
Interest: £6,089,132.39 * 0.0505 = £307,455.19
New Balance: £6,089,132.39 + £307,455.19 = £6,396,587.58
After five years, the initial £5 million deposit grows to £6,396,587.58, demonstrating the substantial impact of compound interest on long-term savings.
By understanding and utilising these financial principles, you can make more informed decisions that optimise your borrowing and saving strategies, ultimately maximising your financial growth and security.
Comments