The Difference Between Simple and Compound Interest Explained
What is Simple Interest?
Simple interest is a type of interest that is calculated on the principal amount of a loan or investment. It is calculated as a fixed percentage of the principal amount, typically annually. This means that the interest remains the same throughout the repayment period, and it is only calculated on the principal amount.
For example, if you borrow $10,000 at a simple interest rate of 5%, you would pay $500 in interest per year, regardless of how much of the principal you have already repaid. The total amount you would repay at the end of a 5-year loan term would be $12,500.
What is Compound Interest?
Compound interest, on the other hand, can be seen as interest on interest. It is a type of interest that is calculated on both the principal amount and the accumulated interest. This means that the interest you earn in each period is added to the principal, and the interest is then calculated on the new, higher principal.
For example, if you invest $10,000 at a compound interest rate of 5% for five years, you would earn $2,764.97 in interest, for a total of $12,764.97 at the end of five years. This is because your interest earned in each year is added to the principal, and the interest continues to compound over the life of the investment.
The Key Differences Between Simple and Compound Interest
The key difference between simple and compound interest is that with simple interest, the interest is only calculated on the principal amount, whereas with compound interest, the interest is calculated on the principal amount and the accumulated interest.
Another significant difference is the way that interest is earned. With simple interest, you earn a fixed rate of interest, and you earn the same amount of interest every year, regardless of how much principal you have repaid. With compound interest, you earn interest on your interest, which means that your earnings grow over time.
Furthermore, compound interest tends to be more advantageous for long-term investments as the interest earned will continue to grow over time. On the other hand, simple interest is often preferred for short-term loans or investments, as it is much more straightforward to calculate and understand.
In summary, the key differences between simple and compound interest are the way that interest is calculated and the way that interest is earned. Simple interest is calculated only on the principal amount, while compound interest is calculated on both the principal and the accumulated interest. Simple interest provides a fixed interest rate that does not increase over time, whereas compound interest provides an interest rate that can grow over time. Understanding the differences between these two types of interest can help you make informed decisions about your finances and investments.
Table difference between simple and compound interest
|Simple Interest||Compound Interest|
|Definition||Interest calculated on the initial principal amount only||Interest calculated on the principal as well as the accumulated interest|
|Formula||SI = P * R * T / 100||CI = P * (1 + R/100)T – P|
|Compounding||No compounding||Compounding can be daily, monthly, quarterly, half-yearly or annually|
|Impact on Returns||Lower returns compared to compound interest||Higher returns compared to simple interest|
|Calculation||Easy to calculate||Complex to calculate|
|Usage||Used in short-term loans and simple investments||Used in long-term loans and investments|