Interest is involved in many finance decisions. Whether it is investing or taking a loan, you may have to encounter it in two different forms, simple and compound. That’s why understanding the difference between both of them is crucial. It can assist you in making wise financial decisions.
Lacking the fundamental knowledge about simple and compound interest may put you in trouble, especially when borrowing money. Therefore, you must comprehend what these terms exactly mean, how they are calculated, and how they differ from each other.
In this article, we will walk you through the basic definitions, formulas, and key differences between them. So, if you wish your decisions don’t prove wrong just due to a lack of information about simple and compound interest, read this guide till the end.
What Is Simple Interest?
Simple interest is the easiest form of interest. It refers to the annual percentage that is paid additionally on a loan along with the principal amount. Unlike compound interest, it is charged annually on the original amount borrowed from the lender.
The mathematical expression of the simple interest is as follows:
S.I = P × r × n
In the above formula, P indicates the principal amount, which is also called the loan amount or original amount. Then, r represents the annual interest, and n is the term of the loan, which is usually considered in years. This formula simply tells you how much you will be giving extra on the loan.
To simplify your calculations, use a Simple Interest Rate Calculator to quickly determine how much interest you will pay on a loan or investment over a given time period.
What Is Compound Interest?
Compound interest is a bit more complicated form of interest as compared to simple interest. It involves interest on interest. According to BYJU’S, compound interest is a type of interest that grows on both the principal amount and the added interest. In simple words, the returns or payments on an amount deposited or borrowed will grow more, respectively.
The formula used to estimate the compound interest is mentioned below:
C.I = P × (1 + r/n)t × n − P
In a mathematical expression of compound interest, P shows the original amount of loan or principal amount, r is the interest rate, and t is the number of years interest is charged. Here, the term n represents the frequency of compounding per year.
Key Differences Between Simple And Compound Interest
Simple and compound interest have several key dissimilarities that necessitate understanding the difference between them. Let’s look at them.
Formula Dependancy
The formula of simple interest mainly depends on the principal amount or the loan amount. This dependence on this single factor makes the interest remain constant throughout the loan period. On the other hand, the formula of compound interest is dependent on an additional factor, which is accumulated interest from previous years. This means compound interest doesn’t remain constant with time; rather, it increases over the loan period, making it more complex.
Growth Of Interest
Since the simple interest remains constant, it grows at a linear rate. Also, the steady growth makes it predictable over time. The uniformity in the growth of simple interest makes it ideal for short-term loans. In contrast, compound interest grows exponentially due to the compounding effect on both the principal amount and the accumulated interest. This exponential growth makes it suitable for long-term loans.
Calculation Complexity
When it comes to calculating both types of interest, the formula for simple interest offers more ease than compound interest. This is because it is a straightforward multiplication of three factors, P, r, and t. Furthermore, this manual hassle can also be avoided using an online simple interest calculator. The calculation of simple interest using a digital calculator becomes faster and more accurate. Conversely, the calculation of compound interest is complicated due to dependence on more variables, such as compounding frequency.
Variance In Principal Amount
In simple interest, the principal amount doesn’t change throughout the loan period. For example, if you take a loan of $1000 at a 5% annual interest rate for 3 years, the principal amount will remain the same for the term of the loan. On the other hand, the principal amount doesn’t remain constant. It keeps on increasing each time interest is compounded. For instance, if you borrow $1000 from a bank at a 3% annual interest rate for 5 years, the principal amount after one year will become $1050. And it will increase with each compounding, which means that it will not remain the same as it was at the start.
Return Amount
In case you invest money instead of taking a loan, then the compound interest proves more beneficial. Returns are generally higher with compound interest compared to simple interest. This is because compound interest involves calculating returns not only on the principal amount but also on the accumulated interest from the previous periods. Due to this, the return grows faster in compound interest. Conversely, the returns in simple interest are much lesser as its growth remains uniform throughout the investment period.
Wrapping Up
After reading this article, we hope that it’s clear to you now how simple and compound interests are different. Now that you understand the difference between them, it will be easy for you to determine which type of interest you should use when investing or borrowing money.
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