Table of Contents
What is Simple Interest?
Simple interest is calculated based on a loan’s principal or the initial deposit into a savings account. Simple interest doesn’t compound, therefore a creditor will only charge interest on the original amount, and a borrower will never be required to pay further interest on the interest that has already accrued. It is the most basic way to calculate the cost of a debt.
It is a method of calculating interest that does not take into consideration numerous periods of interest payments. The interest rate will not be modified by any interest accrued; it will only apply to the principal amount of the loan or investment.
Under the simple interest technique, interest is always added to the initial principal sum, and the rate of interest is constant over time. We receive this type of interest when we deposit money in a bank.
The formula for calculating simple interest is;
Principal x rate x time ÷ 100. The rate of interest is always a percentage so it is taken to be r/100.
What is Compound Interest?
Compound interest is interest that builds up over a set length of time on both principal and interest.
The interest that is paid on both principal and interest and is compounded on a regular basis is known as compound interest.
It is interest that is gained on interest that has already been earned and reinvested.
Compound interest is calculated on a regular basis, such as annually, semi-annually, quarterly, or even monthly. This is similar to how reinvested interest on an investment accelerates the growth of the principal over time.
For instance, you invest $2,000 and it earns 5% interest, or $100 per year. In a compound interest scenario, that $100 would be reinvested and become part of your investment.
The initial $2,000 investment is called the principal.
Now, you have $2,100 invested. At the same 5% interest rate you’ll now get $105. So, your total after two years is $2205.
Difference Between Simple Interest and Compound Interest
- In simple interest, the principal remains the same after every year. In compound interest, the amount earned at the end of one year is the principal for the next year.
- In simple interest, the interest rate is for the principal alone. In compound interest, the interest is on the previous interest plus the principal.
- The formula for calculating simple interest is P * R * T/100 where,
P = Principal
R = Rate
T = Number of time periods.
The formula for calculating compound interest is
A = P(1+(R/100)T
A = Amount
P = Principal
R = Interest rate
T= Number of time periods
- Simple interest is commonly used for short-term loans of 30 to 60 days, whereas compound interest is used for long-term loans.
- Simple interest is often a predetermined percentage of the principal amount borrowed or lent paid or received over a specific time period. Borrowers are required to pay interest on interest in addition to principal since compound interest accrues and is added to the accrued interest from prior periods.
Comparison Between Simple Interest and Compound Interest
|Parameter of Comparison||Simple Interest||Compound Interest|
|Principal||The principal remains the same after every year.||The amount earned at the end of one year is the principal for the next year.|
|Interest Rate||The interest rate is for the principal alone.||The interest is on the previous interest plus the principal.|
|Formula||P * R * T/100||A-P A = P(1+(R/100)T|
|Terms||Is commonly used for short-term loans of 30 to 60 days,||Is used for long-term loans.|
|Payment||is often a predetermined percentage of the principal amount borrowed or lent paid or received over a specific time period.||In compound interest, debtors are required to pay interest on interest in addition to principal since compound interest accrues and is added to the accrued interest from prior periods.|