When a person borrows money from the money lender or any bank/financial institution, some extra amount is charged by the lending entity for the use of money, called as interest. The interest rate is mutually decided by both the parties. Interest can be charged in two ways, i.e. simple interest and compound interest. The former is the type of interest where the interest is charged only on loaned amount but in the case of the latter interest is calculated on the amount lent plus accumulated interest.
So, simple interest is the sum paid for using the borowed money, for a fixed period. On the other hand, whenever the interest becomes due for payment, it is added to the principal, on which interest for the succeeding period is reckoned, this is known as compound interest. So, here in this article, you will find the basic differences between Simple Interest and Compound Interest, which we have compiled after an in-depth research on the two terms.
Content: Simple Interest Vs Compound Interest
- Comparison Chart
- Definition
- Key Differences
- Video
- Example
- Conclusion
Comparison Chart
| Basis for Comparison | Simple Interest | Compound Interest |
|---|---|---|
| Meaning | Simple Interest refers to an interest that is calculated as a percentage of the principal amount. | Compound Interest refers to an interest which is calculated as a percentage of principal and accrued interest. |
| Return | Less | Comparatively high |
| Principal | Constant | Goes on changing during the entire borrowing period. |
| Growth | Remains uniform | Increases rapidly |
| Interest charged on | Principal | Principal + Accumulated Interest |
| Formula | Simple Interest = P*r*n | Compound Interest = P*(1 + r)^nk |
Definition of Simple Interest
Simple Interest is the interest which is charged as a percentage of the original amount lent or Principal, for the whole borrowing period. Interest is the price paid for the use of funds or income received from lending the funds. It is the easiest and fastest method to calculate the interest on the amount lent or borrowed. The most common example of Simple Interest is the car loan, where interest has to be paid only on the original amount lent or borrowed. The following formula is used to calculate the amount of interest:
Where P = Principal Amount
i = rate of interest
n = number of years
Definition of Compound Interest
Compound Interest is the interest which is computed as a percentage of revised principal, i.e. Original principal plus accumulated interest of prior periods. In this method we sum up the interest earned in the previous years to the initial principal, thus increasing the principal amount, on which the interest for the next period is charged. Here, interest is to be paid on the principal as well as the interest accrued during the loan term.
The time interval between two interest payment period is known as Conversion Period. At the end of the conversion period the interest is compounded like:
| Conversion Period | Compounded |
|---|---|
| 1 day | Daily |
| 1 Week | Weekly |
| 1 Month | Monthly |
| 3 Months | Quarterly |
| 6 Months | Semi-annually |
| 12 Months | Annually |
Normally, the banks pay interest on half yearly basis, but financial institutions have the policy of paying interest quarterly. For computing compound interest you have to use this formula:
n – 1}
Where, P = Principal
n = number of years
i = rate of interest per period
Key Differences Between Simple Interest and Compound Interest
The following are the major differences between simple interest and compound interest:
- The interest charged on the principal for the entire loan term is known as Simple Interest. The interest computed on both principal and the previously earned interest is known as Compound Interest.
- Compound Interest gives a high return as compared to Simple Interest.
- In Simple Interest, the principal remains constant while in the case of Compound Interest the Principal changes due to the effect of compounding.
- The growth rate of Simple Interest is lower than the Compound Interest.
- Calculation of simple interest is easy while the calculation of compound interest is complex.
Video: Simple Vs Compound Interest
Example
Suppose Alex deposited Rs. 1000 to a bank at 5% interest (simple and compound) p.a. for 3 years. Find out the total interest that he will get at the end of the third year?
Simple interest =
Compound interest =
Conclusion
Interest is the fee for using someone else’s money. There are many reasons for paying interest like time value of money, inflation, opportunity cost, and risk factor. Simple Interest is quick to calculate, but Compound Interest is practically difficult. If you compute, both simple interest and compound interest for a given Principal, Rate, and Time, you will always find that compound interest is always higher than the simple interest due to the compounding effect on it.