So, what is the difference between simple interest and compound interest?
It goes without saying that one is simple and the other is kinda complex, taking the clue from the names.
Interest in simple terms is the fees charged on amount borrowed. The lender and borrower must have had a mutual agreement on the interest rate.
For example, financial institutions like banks and loan platforms charge an interest on the loans taken by the customers.
People deposit money in the banks to earn interest on the amount deposited. Yes, that’s how it works; its like saving your funds and lending banks your money at the same time.
When it comes to calculating interest rates, what’s the difference between simple interest and compound interest?
Simple Interest
Simple interest is a quick and easy method of calculating the interest charge on a loan. It is calculated by multiplying the daily interest rate by the principal, by the number of days that elapse between payments.
Formula: P ( R * T )
So, for example: Mikel keeps $ 500 in a bank for a period of 1 year at 5% interest rate. Calculate the Simple interest vs compound interest (compounded annually)?
Simple Interest:
Principal = $500
Rate = 5%
Time = 1 year
$500*0.05*1= $25
Compound Interest
Compound interest is the interest on a loan which is paid on the principal and accumulated interest from the previous periods of the loan.
There are multiple types of compounding interest based on the frequency it is compounded. These vary from anywhere from continuous to annual compounding.
Formula:
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
Here’s a quick infographic by: Wallstreetmojo for a summary of simple interest vs compound interest.
Here’s a summary comparison between these two business terminologies – simple interest and compound interest
| Simple Interest VS Compound Interest | Simple Interest | Compound Interest | ||
| Definition | Simple Interest is earned only on the principal amount | Compound interest is on the principal as well as the interest accrued over time | ||
| Amount of interest earned | The amount of interest earned is small and leads to lesser wealth growth | The amount of interest earned is higher and wealth growth increases as the interest are earned on the accumulated interest in the precious periods | ||
| Returns on principal | Fewer returns as compared to compound interest | Higher returns than the simple interest due to compounding | ||
| Principal | The principal remains same during the tenure | Principal increases as interest are compounded and are added to the original principal | ||
| Calculation | Simple interest is easy to calculate | Compound interest is bit complex in calculation than simple interest | ||
| The frequency of interest rate | Does not depend on the frequency of interest accumulation | It depends on the frequency of interest calculation and the amount increases if the frequency increases | ||
| The formula | P * R * T/100 | P (1 + r/100)T – P | ||
| Amount earned after the duration | P * R * T/100 + P | P (1 + r/100)T |