Difference between Simple Interest Rate vs Compound Interest Rate
An income for the person who lends money, and an expense for the person who borrows money, interest may be defined as the charge or fee for using the borrowed money. It is a good thing because you will let institutions borrow your money and then they use it for issuing loans, it is the incentive that individual institutions use. Earlier interest was only offered on savings accounts and some high-end checking accounts by most of the financial institutions such as banks and credit unions.
Whenever interest rates are raised or they fall, we usually hear about the interest rates from the federal funds rate. As the interest rates go high it will cause inflation to fall as the demand for goods and services will drop.
In the financial world to transform small savings into a big corpus over time, the principal of compounding growth is used extensively. It is also an underlying idea behind the ‘time value of money’ and ‘discounted cash flow valuation’.
There are basically two ways of calculating interest rate; Simple Interest Rate vs Compound Interest Rate. The simple interest rate, on one hand, is calculated as a percentage of the principal while the compound interest rate, on the other hand, is calculated as a percentage of both the principal and interest rate.
Formulas for both are given below:
Simple Interest = Principal * time * rate
Compound Interest = Principal (1 + rate / number) ^number * time – Principal.
For example, let’s say that a bank has a 5% Interest Rate, and you borrow $1000 for 10 years, after 10 years you will owe the bank $500 in simple interest terms. And for compound interest if for instance in the same bank you deposit $1000 in a five-year FD at 4% that is compounded monthly, then using the above formula you can calculate the interest rate as $221.
Banks levy Simple Interest Rates to the principal part only. Compound Interest Rate includes calculation on both principal and interest rate. In this, the interest can be compounded at any interval and the most common compounding intervals are daily (365 times a year), weekly (52 times a year), monthly (12 times a year), quarterly (four times a year), and annually (once a year).
The interest rates are mutually decided by two parties, the person who borrows the money and the moneylender i.e. any bank/ financial institution.
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Simple Interest Rate vs Compound Interest Rate Infographics
Below is the top 6 difference between Simple Interest Rate vs Compound Interest Rate
Key Differences between Simple Interest Rate vs Compound Interest Rate
Both Simple Interest Rate vs Compound Interest Rate are popular choices in the market; let us discuss some of the major differences: –
- Simple Interest Rates – Interest is not charged on any accumulated interest in this method and is usually charged on the short-term borrowings whereas in compound interest rates the interest is charged both on principal plus the accumulated interest. The amount of principal is added to the amount of interest to calculate the interest rate for the next period and the interest is reinvested to earn more interest.
- The Simple Interest Rate calculates the interest which is computed on the principal amount, Compound Interest Rate calculates the interest which is computed on principal as well as the accumulated interest rate. Hence compound interest is greater than simple interest.
- Since the calculation is only on the principal amount, for simple interest, its calculation is easier compared to the calculation of the compounded interest. Simple interest is usually calculated for a fixed period of time.
- If the priority over time is not to let your money value fade away the compound interest should be used as money changes over time. The value of a dollar today is more than the value of a dollar which is to be received one year from now.
- While using the principal amount it is important to understand that it is the original money borrowed from an individual or a financial institution. The simple interest uses the principal amount while compound interest adds the interest to it as well.
- Growth in the simple interest calculation remains uniform while in the compound interest formula it increases rapidly.
Head to Head Differences between Simple Interest Rate vs Compound Interest Rate
Here are the key differences between Simple Interest Rate vs Compound Interest Rate –
| The basis Of Comparison | Simple Interest Rate | Compound Interest Rate |
| Related to | Short-term borrowings | Long-term borrowings |
| Meaning | The Simple Interest Rates are charged on the amount originally lent i.e. the principal amount only. | Compound Interest Rates, on the other hand, is calculated on both the principal and the interest rate accumulated over the years. |
| Calculation | Simple Interest Rate formula is S.I= P*R*T where P is the principal, at a Simple Interest Rate r for the time period t, which will give the final interest value S.I. | The calculation is C.I. = P(1+r/n) ^nt – P, where P is the principal, at an interest Rate r for the time period t, n is the number of times the rate is compounded which will give the final interest value C.I. |
| Impact | Simple Interest Rates impact the principal amount and the total earning is less. | The total earning is more as the interest rate is also taken into consideration. |
| Preference | The preference for the Simple Interest Rates is lower. As the only principal is into consideration. | The preference for compound interest is higher and is the more common method of calculating interest. |
| Ease | The fastest and easiest way to calculate the interest on the amount lent | It is a more complex form of calculating interest rate as the principal is revised with time. |
Conclusion
Many borrowers are not aware of the fact that both Simple Interest Rate vs Compound Interest Rate calculates the interest to be charged. The difference between Simple Interest Rate vs Compound Interest Rate is very important as one can end up getting hundreds of dollars less for a deposit.
Compound interest is a more detailed measure of the borrowing as it includes the Simple Interest Rates along with the principal amount. The more often the interest is compounded the more is the interest earned or paid as the amount is accumulated with every time period and the calculation is done on the revised amount.
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