Simple Interest vs Compound Interest Difference Between Simple Interest and Compound Interest

Simple interest refers to the interest which is calculated on principal amount that is borrowed or invested by the person whereas compound interest refers to the interest which is calculated on principal amount that is borrowed or invested by the person along with the previous period’s accumulated interests.

Interest is the fees paid by the borrower to the lender for borrowing money. For example, banks charge interest on the loans taken by the customers. People deposit money in the banks to earn interest on the amount deposited. Higher interest rates higher is the opportunity for investors to earn higher rates of return.

There are two ways to calculate the interest on the principle: Compound and the .

What is Simple Interest?

Simple interest, as the name suggests, is simple in the calculation and to understand. It is the amount that the lender charges the borrower on only the principal loan.

Where SI is Simple Interest

• P is Principal
• R is the rate
• And T is the time for which the loan is given.

The amount owed at the end of the period is given by

A = SI + P or A = PRT/100 + P

For eg:
Source: Simple Interest vs Compound Interest (wallstreetmojo.com)

What is Compound Interest?

Compound interest is the interest earned on the principal amount as well as the interest earned on the accrued interest. Compound interest depends on the frequency of compounding i.e.; the interest can be compounded daily, monthly, quarterly, half-yearly or annual, etc.

The formula to calculate the amount earned when the principal is compounded given as:

Where A is the Amount,

• P is the principal,
• R is the rate of interest.
• T is the time for which the principal is owed

Thus, the Compound Interest is calculated = A – P = P (1 + r/100)T – P

It can be equal to or more than the simple interest depending on the time and frequency of compounding.

Simple Interest vs Compound Interest Infographics

Let’s see the top differences between simple vs compound interest.

For eg:
Source: Simple Interest vs Compound Interest (wallstreetmojo.com)

Examples of Simple Interest vs Compound Interest

Example #1

Consider a person XYZ who keeps \$ 1000 in a bank for a period of 1 year at a 5% interest rate. Calculate the Simple and compound interest (compounded annually)?

Simple Interest = P * R * T/100

• SI = 1000 * 5 * 1/100
• SI = \$ 50

Compound Interest = P (1 + r/100)T – P

• CI = 1000 (1 + 5/100)1 – 1000
• CI = \$ 50

Here, since the interest is compounded annually and the duration of the deposit is 1, both the interest is equal.

Example #2

Now, let us consider the same example and change the duration to 2 years.

Simple Interest = P * R * T/100

• SI = 1000 * 5 * 2/100
• SI = \$ 100

Compound Interest = P (1 + r/100)T – P

• CI = 1000 (1 + 5/100)2 – 1000
• CI = 1102.5 – 1000 = \$ 102.5

Thus, with the change in the duration of the deposit, the interest earned has increased by \$ 2.5. This, \$ 2.5, is basically the interest earned on the interest accumulated in the first year of deposit.

Key Differences

Key Differences are as follows –

• Simple interest is interest only on the principal, whereas is the interest earned on the principal and the subsequent interest accumulated overtime period
• The principal amount remains the same in simple interest, whereas the principal amount changes as the interest are accumulated over a period of time
• Simple interest does not depend on the frequency of the interest calculation, where compound interest depends on the frequency; the compound interest is higher when the frequency increase.
• Compound interest is always higher than or equal (only if compounded annually and for a term of 1 year) to the simple interest.
• Simple interest has lesser returns to the investor than the compound interest.
• Wealth creation is more when the principal is compounded than if simple interest is used.
• The final amount after the period ends in a simple interest is given by P(1 + RT/100), whereas the final amount in Compound interest is P (1 + r/100)T
• The interest earned when it is simple interest is calculated as P * R * T/100, whereas when the interest is compound, the interest earned is P((1 + r/100)T – 1).

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