Difference Between Simple Interest and Compound Interest

Edited by Diffzy | Updated on: April 07, 2022

       

Difference Between Simple Interest and Compound Interest Difference Between Simple Interest and Compound Interest

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Introduction

When a person borrows money or takes debt from a money lender or a bank/financial institution, the lending body charges a fee for the usage of the money, which is known as interest. Both parties set the interest rate in agreement. Simple and compound interest are the two types of interest that can be levied. The former is a sort of interest in which the interest is charged solely on the loaned amount. In contrast, the latter is a type of interest in which the interest is calculated on the amount lent plus the accumulated interest. The key distinction between simple and compound interest is that simple interest is calculated on the principal amount. In contrast, compound interest is calculated on the principal amount plus the interest compounded for a period cycle.

Simple and compound interest are two essential concepts commonly employed in various financial services, particularly banking. Simple interest is used in installment loans, auto loans, student loans, and mortgages. The majority of savings accounts employ compound interest to pay interest. It provides much more than just interest. This post looks at the difference between simple and compound interest.

The interest rate is computed based on the money invested or borrowed. There are two ways to calculate interest. Simple interest (SI) and compound interest (CI) are the two methods (SI). The interest paid on a loan or investment is known as simple interest. It is based on the amount of the principle. At the same time, CI stands for compound interest. It is based on the principle and the interest from the preceding period. The distinction between simple and compound interest is explained in-depth in this article.

Simple Interest vs. Compound Interest

The way interest grows is the difference between simple and compound interest. Compound interest accumulates to both the principal balance and the accumulated interest, whereas simple interest accrues solely to the principal balance.

Simple interest benefits you when you take funds, whereas compound interest benefits you as an investor. Simple interest is preferable as a borrower since you are not paying the interest mortgage. Simple interest makes it easy to repay debt. Because your profits produce money, compound interest may help you develop wealth over time.

Simple interest is the amount paid for borrowing money for a set period. On the other hand, compound interest occurs when interest is due for payment and is added to the principle, on which interest for the next month is calculated. So, in this essay, we'll go through the fundamental distinctions between Simple and Compound Interest, which we've accumulated after conducting an extensive study on the two words.

Differences Between Simple and Compound Interest in Points

Table: Simple Interest vs. Compound Interest
BASIS OF COMPARISON
SIMPLE INTEREST
COMPOUND INTEREST
DEFINITION
It is the rate of interest on a loan or account's principal amount solely.
The interest is calculated on the principal amount, which includes all of the previous period's collected interests on a loan or account.
PRINCIPAL ADJUSTMENT
In the case of simple interest, the principle remains unchanged.
Throughout the borrowing time, the principle is constantly changing.
INTEREST CALCULATION BASE
The interest rate is regulated and determined only by the original Principal.
For the first period, interest is computed on the original Principal and then on the sum of the initial Principal and accrued interest.
GROWTH
The rate of growth stays consistent and uniform.
The rate of growth has increased significantly.
PROFIT
The returns are consistent and low in comparison.
The rewards are dynamic and greater than fundamental interest.
PRINCIPAL
In the case of simple interest, the principle remains unchanged.
Continually changes over the loan time. Therefore, throughout the borrowing time, the principle is constantly changing.
INTEREST CHARGED
Interest is charged on the Principal
Accumulated interest + Principal
FORMULA
Amount=P*(1+RT), where P is the Principal, R denotes the interest rate, and T denotes the period.
Amount=P*(1+R)N, where P represents the Principal, R represents the rate of return, and N represents the number of periods.

What Is Simple Interest?

Simple interest is the interest rate charged in a percentage of the original principal amount on the loan, a fixed deposit, a savings account, and so on for the entire term, usually divided into one year. The simplest and quickest technique of calculating interest on a specific sum is to use simple interest. Therefore, it is more useful when taking out a loan since the borrower will only have to pay a predetermined amount in interest, even though the borrower may not be able to produce wealth, i.e., earn enough for savings or investments.

In other words, the borrower benefits enormously, but the lender suffers a loss since the borrower is required to pay less, and the lender earns less as a result. It's determined by multiplying the principal amount by the interest rate and the period, then dividing the total by 100. It excludes interest based on past accrued interest and solely uses the original Principal as a foundation. Understanding the idea of simple interest is necessary for solving problems in class, but it is also a necessary ability to manage your funds. You can make sound financial judgments if you have a fundamental understanding of how the principles function. In this post, we'll learn how to compute fundamental interest and apply what we've learned to real-world circumstances.

Let's begin by defining the concepts that are used in primary interest.

The Principal amount(P)

The principle refers to the amount of money borrowed or deposited in a bank. A capital letter "P" denotes the Principal.

Interest (R)

The difference between the amount you earn after depositing and what you pay while repaying a loan. Because interest is measured as a rate or percentage, it is usually symbolized by the letter "R."

Time(T)

This is the time when funds are borrowed or deposited. Months and years are the most common units of measurement for time. The capital letter "T" is used to represent it.

Amount(A)

The sum of total interest and Principal during a specific period is the amount.

How To  Find a Simple Interest?

Simple interest is evaluated by multiplying the principal amount borrowed or lent by the interest rate and the loan's length or payback period.

The formula or method  for calculating simple interest is as follows:

SI = (P × R × T) / 100

Where;

SI stands for simple interest.

P stands for principle.

R is the interest rate (expressed percentage)

T stands for time length (in months or years)

If both the time and the principal amount are known, the simple interest formula is used to compute the interest amount.

The following formula is applied  to calculate the total amount (A):

Amount (A) = Principal (P) + Interest

Where;

The amount(A) reflects the total amount of money repaid at the end of the loan repayment period.

  • A $50,000 invoice, for example, may offer a 0.5 percent reduction if paid within a month. This comes up to $250 for early payment, or a 6% annualized rate, which is a very appealing bargain for the payer.

What Is Compound Interest?

Compound interest is interest computed on the initial Principal plus interest from prior periods. The amount of compound interest earned is precisely equivalent to the number of compounding periods. In other words, the longer the compounding period, the greater the amount of compound interest accumulated.

It is a sophisticated way of computing interest on a specified amount since it includes previously accumulated interest and the principal amount.

It has the reverse impact of simple interest in that it is more profitable to the lender than to the borrower. This is because the borrower must pay more interest owing to the addition of interest on previously collected interest, resulting in a higher profit for the lender. It is computed by multiplying the Principal by one plus the interest rate multiplied by the number of periods evaluated or raised to the power of the number of periods. Finally, the principal amount is subtracted to calculate the interest for the given term.

Compound interest is all about the power of time. The sooner you begin saving or investing, the more time you will have to see your money increase. As a result, it's critical to begin saving for retirement as soon as feasible. When you begin early, the less money you will have to save from your pocket. Compounding can help you increase the majority of your retirement money.

Pay off your debts quickly. Whether via student loans, credit cards, or other means, compound interest works against you when you borrow money. The quicker you set them off, the less you'll owe in the long run.

Compound interest is calculated as follows:

A = P (1 + [r / n]) ^ nt

  • A = the total amount of money acquired over n years, including interest.
  • P stands for Principal (your initial deposit or your initial credit card balance)
  • The yearly rate of interest is denoted by the letters r. (as a decimal)
  • n is the number of times when interest is compounded each year.
  • T = the length of time (in years).

Some Examples Of Compound Interest are listed below :

  • When you deposit money into a bank account that generates interest, such as a savings account, the interest is deposited and added to your account balance. This aids in the development of your equilibrium over time.
  • Your credit card company charges interest on the balance on your card every month. Your balance will remain the same if you never charge anything else to the card and pay the accumulated interest each month. However, if you do not pay enough to meet the increased interest for the month, it will be charged to your credit card debt. The following month's interest is computed using the more considerable amount. This might lead your balance to soar over time.
  • If $5,000 is placed into a savings account at a 5% annual interest rate, compounded monthly, The following is an estimate of the investment's worth after ten years:

A=5000 (1 + 0.05 / 12) (12 * 10) = 8235.05.

So, after ten years, the investment balance is $8,235.05.

Differences Between Simple Interest And Compound Interest in Points

The following are the significant distinctions between simple and compound interest:

  • Simple interest is the interest imposed on the principle for the loan duration. Compound Interest is that which is calculated on both the Principal and previously earned interest.
  • When compared to Simple Interest, Compound Interest yields a higher return.
  • In the case of simple interest, the Principal remains constant; however, in the case of compound interest, the Principal varies owing to the impact of compounding.
  • In the case of Simple Interest, the Principal doesn't change; however, in the case of Compound Interest, the principal changes since it includes interest on interest from earlier periods.
  • When calculating Simple and Compound Interest, Simple interest is more accessible to compute than Compound interest.
  • All of these have negative impacts on both borrowers and lenders. Borrowers gain from Simple Interest, while lenders benefit from Compound Interest. Lenders' earnings are reduced as a result of simple interest. On the other hand, compound interest increases their earnings while increasing the burden on the borrowers.
  • Simple interest grows at a slower pace than compound interest.
  • Simple interest is simple to calculate; however, compound interest is complicated.

Conclusion

Simple interest is determined by the loan's Principal or original amount. Compound interest is computed on the main amount as well as the accumulated interest from prior periods and is, therefore, "interest on interest. Interest is that significant aspect of our lives that we will undoubtedly encounter at some moment. So, rather than avoiding its intricacies, it will be more advantageous to comprehend it in its simplest sense. Understanding the workings and distinctions between simple and compound interest and who and how they benefit is not tricky if a genuine attempt is made. To make the most of everything, carefully evaluate every investment or borrowing activity and grasp and appreciate the benefits that will accrue to you about the interest policy implemented.

References

  • https://www.investopedia.com/articles/investing/020614/learn-simple-and-compound-interest.asp
  • https://scripbox.com/fd/difference-between-simple-interest-and-compound-interest

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"Difference Between Simple Interest and Compound Interest." Diffzy.com, 2022. Tue. 24 May. 2022. <https://www.diffzy.com/article/difference-between-simple-interest-and-compound-interest-65>.



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