A significant part of an ordinary man’s life in today’s world revolves around receiving or paying interest. Not only are businessmen greatly involved in this, but also other people, for instance, who take loans from Banks or other Financial Institutions.
So, interest refers to the cost of borrowing money.
To be able to determine what is in the best interest of any person receiving or paying any interest, one needs to have a knowledge of the different types of interests that are there and how they are different from each other.
Key Takeaways
- Simple interest is calculated only on the initial principal amount throughout the entire duration of the loan or investment.
- Compound interest is calculated on both the principal and the accumulated interest, resulting in interest earned on interest.
- Over time, compound interest leads to more significant growth in investments or higher loan costs than simple interest.
Simple vs Compound Interest
The difference between Simple and Compound Interest is that Simple Interest is calculated on the basis of the principal amount. In other words, Interest on the principal amount for the entire period is called simple interest. Compound Interest, on the other hand, is calculated on the basis of the principal amount along with interest on the accumulated interest from periods.
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Comparison Table
| Parameter of Comparison | Simple Interest | Compound Interest |
|---|---|---|
| Definition | It is the interest paid on only the principal amount of a loan or an account. | It is the interest computed on the principal amount, which includes all the accumulated interests of the previous period on a loan or an account. |
| Change in Principal | The principal does not change in case of simple interest. | The principal undergoes a continuous change during the entire borrowing period. |
| The basis of calculating Interest | Interest is strictly calculated on the initial principal. | Interest is calculated on the initial principal for the first period and thereafter on a summation of the initial principal and accumulated interest. |
| Growth | The growth remains uniform and steady. | The growth sees a substantial increase. |
| Returns | The returns are constant and comparatively low. | The returns are dynamic and comparatively higher than simple interest. |
| Formula | Amount=P*(1+RT), where P= Principal, R= Rate of Interest and T= Time Period | Amount=P*(1+R)^N, where P= Principal, R= Rate of Return, N= Number of Periods |
What is Simple Interest?
Simple interest is the interest that is charged in the form of a percentage of the initial principal amount, in case of a Loan, Fixed deposit, Savings Account, etc., for the whole period, generally taken to be broken up into one year each.
Simple interest is the easiest and fastest method to calculate interest on a particular amount. It does not include interest calculated on previous accumulate interest and only has the initial principal as the basis.
It has better use while taking a loan as the borrower will only have to pay a fixed amount as interest, while it may not be able to create wealth, i.e., earn enough for savings or investments.
In other words, it is greatly beneficial for the borrower, but the lender is at a loss as the borrower needs to pay less, and therefore, the lender earns less.
It is calculated by multiplying the Principal amount with the rate of interest and the time and dividing the entire amount by 100.
What is Compound Interest?
Compound interest is interest calculated on the initial principal, including interest in the accumulated interests from previous periods.
The rate of compound interest generated directly depends on the number of compounding periods. In other words, the higher the compounding period, the higher the compound interest accrued.
It is a complicated method of calculating interest on a specific amount since it also takes into consideration the previously accrued interest in addition to the principal amount.
It has the opposite effect from that of simple interest in the sense that it is more beneficial for the lender than the borrower. This is because the borrower has to pay more interest due to the addition of interest on previously accumulated interests; hence, the lender earns more.
It is calculated by multiplying the principal by one plus the rate of interest, raised to the power of the number of periods. Finally, the principal amount is deducted to determine the specific period’s interest.
Main Differences Between Simple and Compound Interest
It is believed that understanding the difference between technical-sounding terms like Simple Interest and Compound Interest is complex and that it suits only analysts and businessmen; however, that is not so. These differences are simple to configure and easier to understand by any person.
- When the interest is charged on the initial principal amount for the entire term, it is known as Simple Interest, whereas when this interest also includes the interest on the accumulated interests of previous periods, it comes to be known as Compound Interest.
- Compound Interest gives a higher return as compared to Simple Interest precisely because of the inclusion of the previous periods’ profits.
- The principal does not undergo any change in the case of Simple Interest. Still, the principal keeps changing in Compound Interest since it includes interest on interests of previous periods.
- With respect to the calculation of Simple and Compound Interest, Simple interest is comparatively easy to calculate than its Compound counterpart.
- Last but not least, both of them have opposite effects on the borrowers and the lenders. Borrowers are benefitted from Simple Interest, whereas lenders are benefitted from Compound Interest. Simple interest leads to a downfall in the earnings of the lenders. Compound Interest, on the other hand, increases their earning but also increases the burden on the borrowers.
- https://commons.allard.ubc.ca/cgi/viewcontent.cgi?article=1001&context=fac_pubs
- https://www.cairn.info/revue-politique-europeenne-2004-2-page-115.htm
- https://journals.aps.org/prb/abstract/10.1103/PhysRevB.70.195106
- https://dl.acm.org/doi/abs/10.1145/1029632.1029639
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
I always get attracted towards compound interest. Being a CPA, I also advise the same to my clients.