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Difference between simple interest and compound interest

When a person borrows money from the money lender or from any bank / financial institution, an additional amount is charged by the loan entity for the use of the money, called as interest. The interest rate decided mutually by both parties. Interest can be charged in two ways: simple interest and compound interest. The first is the type of interest in which interest is charged only on the amount loaned, but in the case of the latter interest it is calculated on the amount loaned plus the accumulated interest.

So the simple interest the sum paid for the use of the borrowed money, for a specified period. On the other hand, every time the interest becomes due for the payment, it is added to the capital, on which the interest for the following period is calculated, this known as compound interest . So, here in this article, you will find the fundamental differences between Simple Interest and Compound Interest, which we have compiled after a thorough research on the two terms.

Comparative chart

Basis for comparison Simple interest Compound interest
Sense Simple interest refers to an interest calculated as a percentage of the principal amount. Compound interest refers to an interest calculated as a percentage of the principal and accrued interest.
Return Less Relatively high
Main Constant It keeps changing throughout the entire loan period.
Growth Stay uniform Quickly increase
Interest charged Main Main + accumulated interests
Formula Simple interest = P * r * n Compound interest = P * (1 + r) ^ nk

Definition of simple interest

Simple interest the interest that is charged as a percentage of the original loaned or principal amount, for the entire loan period. The interest is the price paid for the use of the funds or the income received from the loan of the funds. the easiest and fastest way to calculate interest on the loaned or borrowed amount. The most common example of simple interest is the auto loan, in which interest must be paid only on the original loaned or loaned amount. The following formula used to calculate the amount of interest:

Formula : Simple interest = P i n

Where P = main quantity i = interest rate n = number of years

For example : if you borrow Rs. 1000 from your friend @ 10% per annum for 3 years, so you must return Rs. 1300 to your friend at the end of the third year Rs 1000 for Principal and Rs. 300 as interest, to keep the amount with yourself. If we add up the principal and interest, then it will be known as the Amount. One thing should be kept in mind, the more money and periods, the higher the interest.

Definition of compound interest

Compound interest is the interest calculated as a percentage of the revised capital, that is original capital plus accumulated interest from previous periods. In this method we add the interest accrued in previous years to the initial capital, thus increasing the principal amount, on which the interest for the next period is charged. Here, interest must be paid on principal and interest accrued during the term of the loan.

The time interval between two interest payment periods known as the Conversion Period. At the end of the conversion period the compounded interest such as:

Mixing conversion period
1 day Daily
1 week weekly
1 month Monthly
3 months Quarterly
6 months Half yearly
12 months Annually

Normally, banks pay interest on a half-yearly basis, but financial institutions have the policy of paying interest quarterly. To calculate compound interest you must use this formula:

Formula : Compound interest = P {(1 + i) n – 1}

Where, P = Principal n = number of years i = interest rate per period

Key differences between simple interest and compound interest

The following are the main differences between simple interest and compound interest:

  1. Interest charged on principal for the entire term of the loan known as Simple Interest. Interest calculated on both principal and previously earned interest known as compound interest.
  2. Compound interest offers a high return compared to simple interest.
  3. In Simple Interest, the principal remains constant while in the case of Compound Interest the Principal changes due to the effect of capitalization.
  4. The growth rate of simple interest is lower than compound interest.
  5. The calculation of simple interest is easy while the calculation of complex compound interest.

Video: Simple Vs Compound Interest

Example

Suppose Alex deposited Rs. 1000 to a bank with 5% interest (simple and compound) pa for 3 years. Find out the total interest you will get at the end of the third year?

Solution : here P = 1000, r = 5% and t = 3 years

Simple interest =

Compound interest =

Conclusion

Interest is the fee for using someone else's money. There are many reasons for paying interest such as the time value of money, inflation, the opportunity cost and the risk factor. Simple interest quick to calculate, but compound interest practically difficult. If you calculate both the simple interest and the compound interest for a given Principal, Rate and Time, you will always find that the compound interest always exceeds the simple interest due to the compounding effect on it.