Compound Interest v Simple Interest in P2P Lending
Novice investors may calculate the net interest they will get on their investment per annum. Seasoned investors look for opportunities to earn compound interest, which is paid out upon ‘maturity’, and strategically invest to receive interest as income (on occasion). Regardless, whether novice or sophisticated you can achieve better rates on your money with peer-to-peer lending (P2P) and it is worth understanding how interest rates work and how they differ. Read about our top 5 reasons to invest in peer-to-peer lending here.
So what is compound interest and why is it superior to simple interest in the long term?
Concept wise, compound interest is simple; but this simple concept can translate into a significant return on your investment. Even Einstein loved it coining it the ‘eighth wonder of the world’.
How does compound interest work?
The basic idea behind letting your investment mature is the opportunity to earn additional interest on the interest received from your capital. As you receive interest payments you have the option to invest them back in, alongside your principal investment. In short, your funds can grow exponentially.
Compound interest is one of the salient features of peer-to-peer lending. Many investment firms pay a lump sum interest at the end of the term. By investing in P2P lending you can forego monthly withdrawals of interest and reinvest them, if you want, but you don’t have to.
Understanding the math
By now we have focused on the concept that compound interest is where your interest is also reinvested earning additional interest, also referred to as ‘interest on interest’. So how is it actually calculated? Let’s start with how a simple interest calculation works:
So, you have £10,000/- and you invest it at 5% interest per annum — an expected interest rate offered in peer-to-peer lending. What you will earn at the end of the year is £10,000 x 5%, equals to £500. And if you had invested this amount for 4 years, that means a return of £500 x 4, equal to £2000.
Zopa interest calculator
Zopa compound interest breakdown
As you can see from the table you get £155 more when you invest in a compound interest scheme. This makes a substantial difference. You can, depending on the P2P platform and product, opt in and out of ‘automatic reinvestment’. RateSetter have a simple dashboard that gives you the option to reinvest capital and interest or just capital, as can be seen here:
RateSetter investor dashboard
If you are a small investor, compound interest can really help you by making your limited funds work harder. Of course it pays to notice (literally) that you can only reap the benefits of compound interest if you go for a payoff at the end of the investment term. You will have to forego monthly returns, unless you choose to opt into interest withdrawal schemes where only your capital is reinvested, of course.
If you are looking for a long term investment, then compound interest could be for you. If you are looking for a regular pay out simple interest will work better.
On an aside, compound interest doesn’t just give greater returns, it is the best possible way to beat inflation. Interest earned should not sit “idle”. Each day your money is idle, is another day inflation eats at its buying power. Reinvesting mitigates this by ensuring your money is working hard to make more money!
Best interest rates on the market
Whether you’re in the game of investing in peer-to-peer lending for compound interest or simply to achieve some of the best interest rates on the market, you can certainly find a better way to make money on your money with peer-to-peer lending UK. Here are some of the best peer-to-peer lending sites currently in operation:
This giant platform established in 2010 matches you with consumers (individuals) seeking loans for various reasons, as well as SME businesses and property projects.
Security: no (some investments will have some form of security)
Interest rate range: 2% – 6% per annum
This property focused lending platform matches investors with borrowers seeking to develop property projects. Formed in 2013 this lending platform is one of the top property specialists in peer-to-peer lending UK.
Security: yes, asset secured
Interest rate range: 3% – 3.75% per annum
This lending platform has a broad product-set, including manual loan selection as well as energy efficient investments and SME business investments. Founded in 2012 they are a platform with the largest potential rate of return, if you choose to manually invest.
Auto-diversification: yes (manual loan selection product excluding)
Security: yes, asset secured
Interest rate range: 3.75% – 7% per annum (up to 19% with manual loan selection product)
This progressive platform, launched in 2014, offers multi-financing options from donations to equity and debt-based investments, to UK SME businesses. They are one of few peer-to-peer lending UK platforms capable of offering the tax-efficient Innovative Finance ISA (IFISA).
Security: yes, personal director guarantees
Interest rate: 8.7% APR (avg)
Read our Crowd2Fund Investment Review to learn more about their products, security and IFISA offering.
This platform specialises in businesses loans, which can be secured or unsecured, depending on the borrower(s) you manually select to invest in. Formed in 2013 Rebuilding Society is popular due to the high rate of return it offers peer-to-peer investors.
Security: yes, asset secured (some investments will be unsecured loans)
Interest rate range: 14% – 18% per annum
Yes compound interest is great. Yes peer-to-peer lending gives you the opportunity to earn compound interest. However you need to understand the following:
- With P2P lending your capital is lent out multiple times during the term, so when you choose to “automatically reinvest” it may not always mean the full capital and interest are being reinvested. Although it is likely that it will be.
- Different peer-to-peer lenders offer different products with different withdrawal and reinvestment features, so it is important to check with your chosen P2P lender when reinvesting capital and/or interest.
- Compounding offers greater returns, but it will be for naught if you get too low an interest rate. Ensure
- that the rate of your investment scheme is above the average inflation rate. Otherwise you will lose out in real terms.
- If manually selecting loans ensure that you’re comfortable with your repayment scheme as some loans will
- pay back on maturity, bi-annually, quarterly and other.
To quote Giles Andrews’ the founder of Zopa:
Compound interest is an incredibly powerful way to grow an initial investment, and the longer the money is invested or relent the bigger the compounding effect. While some lenders will prefer a regular income stream, for those wondering whether compound interest is the right strategy for them, it’s hard to argue with Albert Einstein as he famously said, ‘He who understands it, earns it… he who doesn’t pays it’ (Zopa Blog).