What is the Difference Between Simple and Compound Interest
It is essential that anybody involved in a business dealing or any kind of financial transaction, knows the distinction between simple and compound interest. Besides providing ready-to-use calculators, the differences between the two are clearly identified in here.
What is Interest?
Before we talk about types of interest, let me define what interest means in financial terms. Interest is simply the cost of using a specific monetary amount for a period of time. When you borrow money in the form of a loan from a bank, you must pay the cost of using the money in the form of interest to the bank.
When you invest money in a time deposit with a bank, the financial institution pays back the cost of using your money in the form of interest. The amount of money that is borrowed or invested is known as the principal and the cost of using the principal is calculated by specifying the 'interest rate', which is a percentage of the principal.
Simple Interest: Definition & Formula
When calculating interest on a principal amount for a period of less than a year, simple interest rate formula is used. It is the interest calculated on the basis of the principal amount only, without the inclusion of interest earned from the past. Typically, when the period of loan usage extends for a few months or days, simple interest is calculated. Here is the calculation formula:
Simple Interest (SI) = P x R x T
where 'P' is the principal amount, 'R' is the interest rate and 'T' is the period for which interest is charged, which may be counted in days, months or years.
Simple Interest Calculator
Here is a simple interest rate calculator for you. Just enter the principal (in USD), number of years and interest rate in percentage to get the interest value in USD.
Compound Interest Rate: Definition & Formula
Compound interest is calculated on the basis of principal plus the interest earned from previous periods. This type of interest is usually charged when the period of investment extends over more than a year. The principal value for compound interest calculation increases with time as the interest earned from previous years is added to it. Thus the interest is compounded over each succeeding year. Here is its calculation formula, presented in terms of final value (principal plus interest) for a specific period of time:
A = P (1 + R/N)TN
where A is the final amount, R is the compound interest rate, N is the number of compounding periods in a year, T is the total number of years for which interest is calculated.
Calculator
Here is a compound interest rate calculator, which you could use. Enter the principal value (in USD), interest rate, the number of compounding periods in a year and the number of years. (For biannual compounding interest rate, enter the number of compounding periods to be 2 and for quarterly compounding interest rate, enter the number of compounding periods to be 4.)
How Simple and Compound Interest Differ
Thus the prime difference between simple and compound interest is the inclusion of interest earned from previous years. Simple interest is 'simple', because it doesn't include the previous year's earnings. On the other hand, compound interest rate is named so, because it includes the compounded interest from previous years. Here is a table illustrating the difference between the two interest types. Consider the interest earned on an investment of $10,000, which earns a yearly interest of 10%. Notice the increasing difference between the two kinds of interest, over a period of 5 years.
| Year | Simple Interest | Compound Interest |
| 1 | $1000 | $1000 |
| 2 | $2000 | $2100 |
| 3 | $3000 | $3310 |
| 4 | $4000 | $4641 |
| 5 | $5000 | $6105.10 |
Check out how simple and compound interest values differ for the same principal amount, interest rate and period of usage, using the above calculators. As discussed before, the prime difference, that should be noted, is the fact that compound interest calculation procedure includes addition of interest accrued from earlier years to the principal, while simple interest doesn't include it. Consequently for the same principal amount, rate and period of usage, a loan with compound interest will cost more. Any monetary investment you make in the form of a certificate of deposit or other such monetary investments earn compounded interest for you.
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