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When choosing a financial product, it’s important to understand the difference between simple and compounding interest. Simple interest doesn’t include the effect of compound interest on the total amount of money owed. Compound interest includes interest payments on earned interest and is therefore typically higher than simple interest.
What is Interest?
The money you borrow from a bank is called a principal, and the bank charges interest on this amount. Interest compounds depend on the bank’s payment plan. Simple interest only considers the principal for its calculation, while compound interest considers the principal, plus any interest accrued in the current period.
Interest is the cost of borrowing money. The interest rate may be calculated for a single period or over several periods. The important distinguishing feature of compounded interest is that the amount of interest paid in each time period is added to the total principal and becomes part of the principal against which future interest is calculated.
Interest can be calculated daily, monthly, annually, or for any other period of time. For example, you may make a one-time payment by check and earn simple interest from the date of deposit until the date of withdrawal. “Compound interest” re-invests each earning period.
In simple interest is a fee charged by the lender to the borrower for the use of assets. It can be paid at any interval, such as annually, monthly, or daily.
Simple Interest
Simple interest is a fast and easy method to find the interest charge on a loan. Simple interest is determined by multiplying the daily interest rate by the principal by the number of days that elapse between payments. Interest on loans is usually quoted as an annual percentage rate, so to calculate simple interest, multiply the annual rate by the principal by the time period in years.
Simple Interest Formula
The simple interest formula where as follows:
Simple Interest=(P×r×n)/100
where,
P=Principal amount
r=Annual interest rate
n=Term of loan, in years
Compound interest
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest rather than paying it out so that interest in the next period is then earned on the principal sum plus previously accumulated interest. It is the result of reinvesting the interest, rather than paying it, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Compound interest can have a significant effect over time, especially if the interest rate is relatively high.
With compound interest, the amount on which the real interest is calculated increases each year. In other words, compound interest has accumulated interest as well as principal. This can lead to enormous amounts of capital, generating a very high rate of return when funds are invested for a long time and at high rates of interest.
Compound Interest Formula
Compound Interest=P×(1+r)t−P
where,
P=Principal amount
r=Annual interest rate
t=Number of years interest is applied
Simple Interest vs. Compound Interest
Criteria | Simple Interest | Compound Interest |
It is the total amount that is paid to the borrower for using the borrowed money for a fixed period. | It earns interest on the already earned interest and also the principal amount. | |
Formula | Simple Interest = P*I*N | A=P(1+r/n)(n*t) |
Interest is Levied on | Principal amount | The principal amount and also the interest that accumulates |
Growth of wealth | Wealth grows steadily | Wealth growth is exponential due to compounding |
Returns from the interest | It Returns lesser comparison to compound interest | We get Higher returns in comparison to the simple interest due to interest on interest |
Principal Amount invested | It remains the same with tenure | Principal increases. Interest gets compounded and gets added to the principal. |
Conclusion
The two types of interest are Simple interest and compound interest. The main difference between simple and compound interest is that compound interest is calculated on the principal plus any accrued interest, whereas simple interest only earns money on the principal amount. Therefore, with simple interest, the total amount owed at the end of the loan term is exactly what you borrow. In contrast, if you use a credit card and are just paying off your monthly minimum, you will be liable for both simple and compound interest and will likely owe even more money than what’s shown on your balance. In either case, it pays to pay back your loan as quickly as possible. Calculate and compare how much money you can save by paying off different amounts each month using our handy loan calculator above!
