Difference Between Simple Interest vs Compound Interest
Anyone who thinks of taking a loan first looks at the cost of doing so. If you want to borrow, then you will look at the lowest rates possible. However, from an investor’s point of view, a high rate will be beneficial.
When a borrower borrows money from a lender or any financial institution or bank, there is some extra amount that is charged on the total amount that is borrowed. This extra amount is termed as an Interest rate. Interest charged can be of two times Simple Interest vs Compound Interest. Simple interest is charged only on the loan amount, and Compound interest is charged and calculated on the loan amount and on the accumulated interest.
To summarize, the concept of simple interest is the amount paid for the money borrowed for a fixed period of time. While in the case of compound interest, whenever the interest is up for payment, it is added back to the principal amount. In this Simple Interest vs Compound Interest article, we will highlight the differences between simple interest and compound interest.
Head To Head Comparison Between Simple Interest vs Compound Interest (Infographics)
Below is the top 8 difference between Simple Interest vs Compound Interest
Key Differences Between Simple Interest vs Compound Interest
Both Simple Interests vs Compound Interest are popular choices in the market; let us discuss some of the major difference :
- Simple interest can be defined as the interest charged on the total principal amount taken for a particular period of time. Interest is only charged based on the use of funds. The calculation of simple interest is quite straightforward and is the fastest way to calculate interest. An example of simple interest is car loans, where the interest has to be paid on the amount borrowed.
- Compound interest is calculated on the revised principal. The revised principal is calculated based on the interest charged on the accrued interest. The principal amount, therefore, keeps on increasing. The higher the amount of loan and periods similar will be the interest. Interest is to be paid on the principal and on the interest accrued
The time interval between the payment or the calculation is known as the Conversion Period. Below are the frequencies and how they are compounded
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- 1 day – Daily
- 1 week – Weekly
- 1 month – Monthly
- 3 months – Quarterly
- 6 month – Semiannually
- 12 months – Annually
- The formula for calculating Simple interest is – P*R*N
(P = Principal, R = Rate, N = No of years)
Formula for calculating Compound interest is – P {(1 + i)n – 1}
- Return on compound interest is higher than on simple interest
- The growth rate of simple interest is lower than on compound interest
- Calculation of simple interest is easier than on compound interest
Example of Simple Interest
If a borrower borrows $1000 from a lender @10% per annum for three years, then the total amount of interest charged will be $300, and the total amount to be paid back will be $1300. The $300 interest is charged for using the amount. The sum of interest and principal is known as the total amount. One point is to note is that the higher the amount borrowed and the higher the number of periods, the higher will be the interest.
Comparison of the amount of Simple and Compound Interest –
Suppose John deposited Rs 1000 in the bank and gets a return of 5% per annum for a period of three years. We will now calculate the total amount he will receive at the end of the third year.
Here,
- Principal (P) = Rs 1000
- Rate (R) = 5%
- Time/Period (T)= 3 years
By using the Simple Interest Formula
- Simple Interest Calculation = (P x R x T)/100
- Simple Interest Calculation= 1000 x 5 x 3/100
- Simple Interest Calculation = 150
Now we will find out the Compound Interest by Using Compound Interest Formula.
- Compound Interest Calculation = P [(1 + R)n – 1]
- Compound Interest Calculation = 1000 x {(1 + 5/100)^3 – 1}
- Compound Interest Calculation = 157.625
Simple Interest vs Compound Interest Comparison Table
Below is the 8 topmost comparison between Simple Interest vs Compound Interest
| Basis Of Comparison |
Simple Interest |
Compound Interest |
| Meaning | It is the interest which is a percentage of the total principal amount | It is the interest which is a percentage of both principal and accrued interest |
| Return for lender | The simple interest offers low returns for the lender | The compound interest offers a comparatively high return to the lenders |
| Principal | The principal is constant for simple interest | Principal for compound interest keeps on changing due to the addition of accrued interest in the entire period. |
| Growth | Principal and interest growth is constant | Principal and interest growth is rapid and increases at a fast pace |
| Interest Charged | Interest is charged on the principal amount only | Interest is charged on the principal, and the interest amount |
| Formula | P*R*N
|
P * (1 + R) ^ NK
|
| Calculation | Calculation of simple interest is very easy, and it is also easy to understand | Compared to simple interest, the calculation of compound interest is difficult as it involves different periods of compounding. |
| Useful | When it comes to buying anything, simple interest will always be better. Most of the car loans calculate based on simple interest. | Compound interest is useful for investing. Since it allows the fund to grow at a faster rate |
Conclusion
Interest can be basically termed as a fee for using someone else’s money. The reasons for paying interest include risk, inflation, time value of money (effect of compounding), and opportunity cost.
As explained in the above formula, simple interest is easy to calculate, and calculating compound interest is difficult and complex. As in the previous example, if we calculate both simple and compound interest for a particular time, rate and principal, then it is observed that compound interest is always greater than the simple interest due to the effect of compounding, also known as the time value of money.
Understanding the difference between these two methods will allow you to pick the right loan and find the best alternative to store your earnings. If you are a borrower and you don’t want to put yourself in a long, expensive debt, then you will obviously look for a loan that does not compound. But if you are an investor who wishes to earn loads of money that you can use later, then you will look for options that will compound, and the frequency is higher.
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