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The amount that is charged on a loan balance when a certain amount of money is borrowed is known as interest.
Simple and compound interest are the two most used methods for calculating interest.
For loans and investments, simple interest is calculated on the principal amount. In the case of compound interest, the interest is levied on the accumulating or previous interest.
The definition of simple and compound interest and where they are is given in the following data.
Simple interest
Simple interest refers to the cost that is borrowed. This interest is only on the principal amount and is calculated as the percentage of the principal amount.
Simple interest is said to be more beneficial for the borrowers since they only have to pay the interest on the loans taken.
The loans in which simple interest is used as car loans and consumer loans. A certificate of deposit also uses simple interest for calculating the return from the investment.
However, there is a chance that the investors may lose if their investments are completely based on simple interest.
Compound interest
Compound interest is added to the principal amount and is interest on interest. When it comes to compound interest, it has the potential to get more money in return than simple interest.
The frequency of compounding can be decided by the lender or bank and can be on a daily, monthly, quarterly, half-yearly, or yearly basis. The frequency of compounding is considered to be inversely proportional to the interest accrual amount.
Compound interest can be used in loans as well. However, it is used mostly in investments, fixed deposits, mutual funds, and other types of investments that have more reinvestment of profits.
However, in the case of compound interest, the investors are said to benefit more than the borrowers.
Simple and compound interest formula
The simple and compound interest formulas along with their examples a given below:
Simple interest
The formula to calculate simple interest is
p*i*n
Where P= principal amount
i= Interest Rate
n= Term of the loan,
For example,
The simple interest at 3% on a $4000 loan that is taken out for a period of 3 years will be $4000×3×0.03=$360.
Compound interest
The compound interest formula is as follows:
A=P×(1+r)t-P
P is the principal amount.
A= Annualized Compound Interest, r=rate, n=number of compounding periods, t=years,
For example,
The compound interest for a loan amount of $10,000 with the rate of 10% for 5 years will be:
A= 10,000×{(1+10%)(5)-1}
A= $6,105
The number of compounding periods is highly essential when computing compound interest and can make a big impact. The amount of compound interest is related to the number of compounding periods.
If the compounding period is more than one side, then variables ‘i’ and ‘n’ have to be adjusted for calculating the compound interest.
By using these formulas, you can calculate simple and compound interest.
Compound and simple interest difference
The simple and compound interest difference is given in the table below:
Parameters | Simple interest | Compound interest |
|---|---|---|
Meaning | Simple interest refers to the total amount paid back to the borrower for using the money in a fixed period of time. | Compound interest is on the previously earned interest and also on the principal amount.
|
Formula, | The formula for simple interest is P×i×n | The formula for compound interest is A=P×(1+r)t-P |
Interest calculated on | The interest is calculated on the principal amount | The interest is levied on the previous interest as well as the principal amount. |
Level of growth | The amount of money grows steadily in simple interest | In the case of compound interest, the amount of growth is exponential because of the compounding |
Amount of returns | In the case of simple interest, there are lesser returns | In the case of compound interest, there are high returns |
These are the differences between simple and compound interest.
Therefore, simple and compound interest are very advantageous and are used for car loans, retailer installment loans, mutual funds, and bank transactions. The concept of simple and compound interest is very simple and can be calculated by the formulas given above.
Conclusion
By investing frequently and increasing the frequency of your loan repayments, you may put compounding to work for you. Learning the fundamentals of simple and compound interest can help you make smarter financial decisions, potentially saving you millions of rupees and increasing your net worth over time.
