Money Savvy

Understanding The Difference Between Flat Rate And Compound Interest

You might think you know a lot about finance, but sometimes jargon can trip up even the savviest of spenders. We recently carried out research to find out whether people really know as much as they think they do about financial terms. And it brought out some interesting results!

Our research on financial terms

Our research covered a selection of core financial terms that we come across every day:

  • Flat rate interest
  • Compound interest
  • Direct debit
  • Continuous payment
  • Credit rating
  • APR

More than half of participants in our research felt they had a good understanding of each of these financial terms. In particular, the vast majority (83%) feel they have a good grasp on credit ratings. 44% knew that being registered to vote can affect your credit rating and 34% of people correctly identified that how often you move to a new house can, too. However, almost a third of people (29%) incorrectly believe that people who lived at your address before you affect your credit rating.

Half of the participants said that they understood the term ‘compound interest’ quite well or very well and 69% said they understood APR. But, only 10% of people knew that APR was a type of compound interest.

A higher number of people (62%) said they understood ‘flat rate interest’ and 44% of people could correctly identify that they’d pay back £12,500 on a £10,000 loan with a flat rate annual interest at 5%.

Financial terms explained

The most significant finding of our research is that while plenty of people think they understand financial terms well, they often don’t understand them fully. There are plenty of misconceptions at play, too.

But, let’s face it, personal finance isn’t the most interesting subject. It’s important to have a good understanding of different aspects of it and make informed decisions, but it can be difficult to engage with and get your head around. So, we made it our mission to take the most commonly misunderstood topic – interest rates – and explain it in a way that’s jargon free. We’re aiming to clear up any lurking misconceptions about different types of interest

What’s The Difference Between Flat Rate Interest & Compound Interest?

We took the most commonly misunderstood topic – interest rates – and created this video to explain it in a way that’s completely free of jargon. As the majority of people learn better when they can visualise what they’re learning, we used chocolate coins to highlight the differences between these two types of interest and explain them in a simple way. No jargon, plus chocolate is a winning combination in our opinion!

We hope that’s helped you to better understand – and calculate – these different types of interest!

Video Transcript

What’s the difference between –a flat rate interest and compound interest?

Flat rate and compound are both types of interest. Interest is money paid regularly at a particular rate alongside a borrowed sum of money.

Let’s say you’ve just taken out a five-year loan with a flat interest rate of 5%.

These five gold chocolate coins represent the money you’ve borrowed. The silver coin is the 5% interest.

Each year you’ll pay off a set amount on the loan, but you’ll also pay interest.

With a flat rate interest loan, you’ll pay the same amount of interest each year.

Let’s put that into numbers.

Say you get a £5,000 loan over five years at 5% interest. The interest you pay per year would be 5% of £5,000, which equals £250.

So, one silver coin, or one year’s interest, equals £250.

The total amount of interest you’ll pay is five times £250, which equals £1,250.

The amount you’ll pay including the loan amount and interest would be £6,250

Now, let’s look at compound interest.

The main difference between flat rate and compound interest is that compound interest adjusts based on how much of a loan is outstanding.

So, let’s look at that £5000 loan again. You’re still charged 5% interest, but this time it’s compound interest. If you pay back £1000 in the first year, then when interest is next added, it’ll be on the remaining £4000.

As you repay more and more of your loan, the amount of interest that’s added to your balance will get smaller and smaller.

Let’s recap…

With a flat rate interest loan, you’ll pay the same amount of interest back with each payment every year. This is a percentage of the entire loan amount. Even if you pay back early, you’ll pay the same amount overall.

With compound interest, interest is added to your balance as you go along. So, if you make bigger payments than you need to, or pay back early, you could pay less interest.

Visit our Money Savvy section for more helpful financial tips.