Difference Between Simple Interest and Compound Interest
In finance, the difference between simple and compound interest lies in their growth patterns. Simple interest is calculated solely on the principal amount, while compound interest considers both the principal and accumulated interest from previous periods. The simple interest offers a linear growth pattern, with interest remaining constant over time, while compound interest showcases exponential growth, as each period’s interest is added to the principal for subsequent calculations. The choice between the two depends on the desired level of growth and the time horizon of the investment or loan.
Interest is the fundamental financial concept for borrowing, lending, and investing. When you borrow money, the interest represents the additional amount you must pay apart from the principal amount. And this is calculated in two ways: Simple Interest and Compound Interest.
Simple interest is interest paid on the principal amount only, while compound interest is paid on the principal amount and any interest earned previously.
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In this article, we will learn what is simple interest, what is compound interest, and the difference between compound interest and simple interest.
So, let’s start!!
Table of Content
- Simple Interest vs Compound Interest: Difference Between Simple and Compound Interest
- What is Simple Interest?
- What is Compound Interest?
What is the Difference Between Compound Interest and Simple Interest?
| Parameter | Simple Interest | Compound Interest |
| Definition | Interest is calculated only on the initial principal amount. | Interest is calculated on the initial principal amount and the accumulated interest from previous periods. |
| Formula | (Principal x Rate x Time) / 100 | Principal x (1 + Rate)^Time – Principal |
| Effect on Returns | Linear Growth | Exponential Growth |
| Impact of Time | Interest Remains Constant | Interest Increases with Time |
| Total Amount | Principal + Interest | Principal + Compound Interest |
What is Simple Interest?
It is a basic method to calculate a loan or investment interest. Simple interest is calculated on the initial principal amount and doesn’t consider any accumulated interest over time.
It simply applies to the original principal amount with the same interest rate for every time cycle.
Formula of Simple Interest
SI = (P x R x T) / 100,
where
SI: Simple Interest
P: Principal
R: Rate
T: Time
Now, let’s have an example to understand better how to calculate the Simple Interest.
Example of Simple Interest
Let you have taken a loan of $1000 from the bank at an annual rate of 8% for 2 years. Then, find the simple interest.
Answer:
Principal Amount = $1000
Interest Rate = 8%
Time = 2 Years
Now, substituting all the values in the formula, we get:
SI = (1000 x 8 x 2) / 100 = 160
Hence, the simple interest will be $160.
Properties of Simple Interest
- Simple interest exhibits a linear growth pattern since the interest remains the same over time.
- Calculating simple interest is a straightforward process, i.e., SI = (PRT) / 100
- Interest is independent of any compounding effect, i.e., each period has the same significance.
- The interest rate remains constant throughout the entire duration.
What is Compound Interest?
Compound interest is a method of calculating interest on a loan or investment where the interest is based on the initial principal amount and the accumulated interest from previous periods. This leads to exponential growth of the investment over time.
The key difference between Simple interest and compound interest is:
The compound interest for an amount depends on both principal and interest gained over periods. While the simple interest for an amount depends only on the principal amount.
Formula:
A = P(1 + r/n)^(nt),
where
A = Amount
P = Principal
r = rate of interest
n = number of times interest is compounded per year
t = time (years)
Formula of Compound Interest
CI = A – P = P(1 + r/n)^(nt) – P
Now, let’s have an example to understand better how to calculate Compound Interest.
Example of Compound Interest
Suppose you invest $10,000 in a fixed deposit account with an annual interest rate of 6%. The interest is compounded annually, and the investment term is 5 years. Find the compound interest.
Answer: Here,
Principal Amount = $10,000
Interest Rate = 6% = 0.06
Time = 5 Years
Compound Interest = 10000 x (1 + 0.06)5 – 10000 = 3903.07
Hence, the compound interest is $3.903.07.
Properties of Compound Interest
- Unlike linear growth of simple interest, compound interest exhibits a characteristic of exponential growth.
- Compound interest is highly dependent on time.
- It is highly sensitive to the rate of interest, i.e., a slight change in interest rate can have a significant impact on the final amount.
Conclusion
In finance, the difference between simple and compound interest lies in their growth patterns. Simple interest is calculated solely on the principal amount, while compound interest considers both the principal and accumulated interest from previous periods. The simple interest offers a linear growth pattern, with interest remaining constant over time, while compound interest showcases exponential growth, as each period’s interest is added to the principal for subsequent calculations. The choice between the two depends on the desired level of growth and the time horizon of the investment or loan.
In this article, we have briefly discussed what simple and compound interest is, their properties and the difference between them. Hope you will like the article.
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Vikram has a Postgraduate degree in Applied Mathematics, with a keen interest in Data Science and Machine Learning. He has experience of 2+ years in content creation in Mathematics, Statistics, Data Science, and Mac... Read Full Bio
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