Definition
Simple interest is a financial concept where the interest is calculated only based on the initial amount (principal) that was deposited or loaned. Compound interest, on the other hand, is where interest is calculated on the initial principal and also on the accumulated interest of previous periods. Therefore, under compound interest, the total amount grows faster than under simple interest.
Key Takeaways
- Simple interest only takes into account the principal amount while calculating interest. It is calculated one time and does not change over the period of the loan or investment. However, compound interest calculates interest not only on the initial principal but also on the accumulated interest from previous periods. Thus, resulting in accumulated interest.
- Simple interest is beneficial for short-term loans and investments as the total amount payable or receivable doesn’t significantly change due to timeframe. But for long-term investments and savings, compound interest significantly amplifies the total amount as the interest is able to compound over time.
- Calculating simple interest involves a straightforward formula i.e., (Principal x Rate x Time). On the other hand, calculating compound interest requires a more complex formula (P(1 + r/n)^(nt)) where P is the principal amount, r is the annual interest rate, n is the number of times that interest is compounded per unit t, t is the time the money is invested or borrowed for in years.
Importance
Understanding the difference between simple interest and compound interest is crucial in the world of finance as it can significantly impact the return on your investments or the cost of your loans.
Simple interest calculates the growth of your investment or loan based on the initial principal, meaning the interest doesn’t compound or accumulate over time.
On the other hand, compound interest includes the accumulation of interest on both the initial principal and the prior interest earned, resulting in exponential growth.
Therefore, when investing, compound interest can dramatically increase your return over time, whereas when borrowing, it can significantly increase the total cost of your loan.
Knowing the difference allows for more informed financial decisions.
Explanation
Simple interest and compound interest are important concepts in finance that essentially deal with the growth of a sum of money over time. Simple interest is primarily used for short-term loans and investments where interest is calculated only on the initial amount (or principal) that was deposited or borrowed. It’s often used in car loans, short-term personal loans, and certain savings accounts.
The primary purpose of simple interest is to provide an uncomplicated rate of interest that doesn’t automatically compound over the life of the loan or investment. This makes predicting the total cost of the loan or the total return on an investment very straightforward. On the other hand, compound interest is typically used for long-term loans and investments.
It offers a potentially higher return or cost as it calculates interest on both the initial principal and the accumulated interest from previous periods. It could apply to savings accounts, credit card loans, mortgages, and most other forms of loans and investments. The compounding effect can significantly increase the growth of investments over time, which particularly benefits long-term saving.
In loans, it ensures that lenders are properly compensated for the total risk assumed over the extended lifespan of a loan, as compound interest technically treats each period’s accumulated interest as a new loan. This is why understanding the difference between simple and compound interest is crucial for anyone planning to borrow or invest money.
Examples of Simple Interest vs Compound Interest
Saving Accounts: Most bank savings accounts operate using compound interest, where the interest earned gets added back to the original principal, increasing the total amount on which future interest is calculated. On the other hand, if a bank savings account operated on simple interest, the interest income would remain separate from the principal. Over time, the account with compound interest would grow at a faster rate because compound interest essentially lets you earn interest on your interest.
Credit Cards: Credit cards often use compound interest, charging interest on the amount unpaid at the end of the billing cycle. So, if you don’t pay off in full each month, you’ll be charged not only on your initial borrowing but also on the accrued interest, leading to a larger debt. Whereas if they charged simple interest, it would only be applied to your original balance, making the overall amount owed less.
Mortgage Loans: Simple interest is commonly used in car loans and mortgage loans – calculated on the original loan amount for the entire term. For example, a 5-year loan for $20,000 at an annual interest rate of 5% would cost $1,000 a year in interest, totaling $5,000 over the 5 years. Conversely, if it were a compound interest loan, you would end up paying more in interest because the interest gets added to the initial loan amount and then further interest is charged on the new increased balance.
FAQ: Simple Interest vs Compound Interest
What is Simple Interest?
Simple interest is calculated only on the principal amount, or on that portion of the principal amount that remains. It does not account for the effects of compounding.
What is Compound Interest?
Compound interest is calculated on the initial principal and also on the accumulated interest of previous periods. It can thus be regarded as “interest on interest” and will make a deposited or borrowed sum grow at a faster rate than simple interest.
What is the main difference between Simple Interest and Compound Interest?
The main difference is that compound interest takes into account the accumulated interest, while simple interest does not. In other words, with compound interest, you earn interest on the money you’ve already earned interest on, whereas with simple interest, you don’t.
Which is better, Simple Interest or Compound Interest?
This depends on whether you are the lender or borrower. If you are investing, compound interest is better. Your initial deposit or investment will grow more quickly with compound interest because you’re earning interest on the money you have already earned interest on. If you owe money, it is typically better if the money owed is calculated using simple interest, as you will owe less.
How often is interest compounded?
Interest can be compounded on any given frequency schedule, from continuous to daily to annually. The period of time in which interest is compounded is dependent on the specific terms put forth by the bank or lending institution.
Can I choose between Simple and Compound Interest?
When it comes to investments, savings accounts and most loans, the type of interest – whether it’s compound or simple – is predetermined by the bank or lending institution. You typically can’t choose the type of interest calculation used.
Related Entrepreneurship Terms
- Principal Amount
- Interest Rate
- Time Period
- Annual Compounding
- Quarterly Compounding
Sources for More Information
- Investopedia – It has a vast repository of financial terms, explanations, and comparisons including simple interest vs compound interest.
- Khan Academy – Offers online courses and explanatory videos on numerous topics in finance, including simple interest and compound interest.
- Corporate Finance Institute – This site provides professional information, courses, and free resources on many topics, such as the difference between simple interest and compound interest.
- NerdWallet – This site gives practical advice and explanations on financial matters, including the differences between simple interest and compound interest.
