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Banks these days offers saving plans that promises a certain percent of interests pay out. In my local banks, saving plans with interests of 1.2% P.A are not uncommon. Due to the recent economy recession and uncertainty in the financial markets, interestes rates of these banks have dropped. I remember it was up to about 2% to 3% about 1 year back.

Here, I did this interesting way to calculate the difference between simple and compounding interest, and found out that simple interest actually pays more ! All along I thought it was the compounding effect that earns more interest. In my scenario, I want show the calculation of both simple and compound interests, and the actual effective interest rate after the end of 2 years.

Here is my scenario, taking a savings of $1000 monthly throughout a year for 2 years.

Simple interest rate based on 1.2%

Savings for 1st year:
$1000 x 12 = $12000

Total interest earned:
$12000 x 0.012 = $144

Total savings as of 31 Dec Year 1:
$12000 + $144 = $12144

Savings for 2nd year:

Savings for a year:
$12144 + ($1000 x 12) = $24144

Total interest earned:
$24144 x 0.012 = $289.72

Total savings as of 31 Dec Year 2:
$24144 + $289.72 = $24433.72

Total interest earned by simple interest for 2 years:
$24433.72 - $24000 = $433.72

Effective interest rate:
$433.72 / $24000 = 0.018 or 1.8%

In summary, if we save $1000 a month on a 1.2 % P.A for 1 year with simple interest calculation,
we will have a balance of $12144, with an earned interest of $144, effective interest of 1.2%.
For 2 years, we will have a balance of $24433.72, with an earned interest of $433.72, and an effective interest rate of 1.8%!!!!

Compound interest rate based on 1.2%

Compound meaning for each month= (1000 + balance) * (0.012 / 12) = new monthly balance.

Calculations for the first year (adding $1000 a month):
1st $1000 * 0.001 = $1 (interest)
2nd $2001 * 0.001 = $2
3rd $3003 * 0.001 = $3
4th $4006 * 0.001 = $4
5th $5010.01 * 0.001 = $5.01
6th $6015.02 * 0.001 = $6.01
7th $7021.03 * 0.001 = $7.02
8th $8028.05 * 0.001 = $8.02
9th $9036.08 * 0.001 = $9.03
10th $10045.12 * 0.001 = $10.04
11th $11055.16 * 0.001 = $11.05
12th $12066.22 * 0.001 = $12.06

Total balance after 12 months:
$12066 + $12.06 = $12078

Total interest earned (1st year):
$78.28

Effective interest rate:
$78.28 / $12000 = 0.0065 or 0.65%

Calculations for the second year (adding $1000 a month):
1st $13078 * 0.001 = $13.07 (interest)
2nd $14091.07 * 0.001 = $14.09
3rd $15105.16 * 0.001 = $15.10
4th $16120.27 * 0.001 = $16.12
5th $17136.39 * 0.001 = $17.13
6th $18153.53 * 0.001 = $18.15
7th $19171.68 * 0.001 = $19.17
8th $20190.85 * 0.001 = $20.19
9th $21211.04 * 0.001 = $21.21
10th $22232.25 * 0.001 = $22.23
11th $23254.49 * 0.001 = $23.25
12th $24277.74 * 0.001 = $24.27

Total balance after 24 months:
$24277.74 + $24.27 = $24302.02

Total interest earned (2nd year):
$224.02

Effective interest rate:
$224.02 / $24302.02 = 0.0092 or 0.92%

Based on a $12000 (1000 a monthly savings with 0.1%), you only earned $78 which is 0.65%.
Which means to say the effective interested rate is only 0.65%, not 1.2% although it is true that 12 months of 0.1 % adds up to 1.2 a year but its compounded.

For 2 years, we will have a balance of $24302.02, with an earned interest of $224.02, and an effective interest rate of 0.92%!!!!

Conclusion

There is still some difference between the 2 after looking at the 2 ways of calculation and for 2 years.

If your local bank or funds management has a plan that give returns of 1.2%, be sure to ask if it is a simple interest rate or a compounded interest, because it may mean alot for long terms savings!