Simple vs. Compound Interest Rates: The Surprising Impact on Annuities

Should you buy an annuity with a 5.5% crediting rate or a 6.0% crediting rate? It seems like an easy question. A higher crediting rate gives you a better return, so the 6.0% crediting rate appears to be the obvious winner. However, there’s a catch. Some annuities use a simple interest rate instead of a compound interest rate, and as a result, your return may not be nearly as good as you expected.

Don’t get fooled into choosing a bad deal. Before you buy, make sure you know what type of interest you’re receiving.

Understanding Simple vs. Compound Interest Rates

Interest is typically expressed as a percentage. However, the percentage isn’t the only factor that matters. You also have to consider how the interest is calculated.

• Simple interest is calculated based on the principal amount. If you start with $10,000 and apply a 6% simple interest rate each year, you’ll earn $600 each year.
• Compound interest is calculated based on the sum of the principal amount and the interest that has accumulated in previous compounding periods. Think about it like this – if you start with $10,000 and apply 6% the first year, you’ll add $600. If you apply 6% to the new total of $10,600 the next year, you’ll add $636. If you apply 6% to the new total of $11,236 the third year, you’ll add $674.16. The actual calculations can be more complicated because you also have to consider how frequently the amount is compounded, and the compounding period can range from daily or even continuously to yearly. However, the point is that the interest growth isn’t stuck at $600 a year. Every year, it grows.

So, which is better – simple interest or compound interest? That depends on the context.

If you’re borrowing money, interest is the additional amount that you have to pay over the life of your loan, so you want to pay as little interest as possible. Simple interest is better. Note that credit cards usually charge compound interest, and that’s why credit card debt can balloon out of control so easily.

If you’re investing money in a high-yield savings account or annuity, interest is the amount your money earns for you – that’s why it can be called the crediting rate – so you want to earn as much interest as possible. In this case, compound interest is better.

Should You Choose a Higher Simple Rate or a Lower Compound Rate?

If you’re given the choice of an annuity with a 6% simple rate or a 6% compound rate, you should definitely choose the 6% compound rate because it will provide a larger yield over time. However, your choice may not be this straightforward. Often, you’ll have to choose between a higher simple rate and lower compound rate. Figuring out which one is better can require a little math.

According to Investopedia, over a 10-year period, a $100,000 deposit with a 5% simple annual interest rate would earn $50,000 in total interest, while a $100,000 deposit with a monthly compound interest rate of 5% would earn about $64,700.

Comparing Apples to Oranges: Don’t Be Fooled!

Fixed annuities typically provide a compound interest rate. However, some companies offer a simple interest rate instead. If you’re not paying attention, or if you don’t know the difference, these offers can be very enticing because the rate is usually higher than what other annuity companies are offering – but that doesn’t mean it’s the better deal.

Comparing a higher simple interest rate to a lower compound interest rate is like comparing apples to oranges.

Don’t be fooled by the higher percentage. Use this compound interest calculator and this simple interest calculator to compare annuity options. Although it can seem counterintuitive, the lower compound rate could easily be the better deal – and the advantage of compound interest continues to increase over time.

Are you looking for a great deal on an annuity? Canvas offers annuities with competitive compound interest rates. Our retirement annuity calculator lets you estimate how much your annuity from Canvas could be worth. Get started.