Introduction
In finance and economics, the price you pay to borrow money is known as interest. It is one type of fee that a borrower pays to a lender and a third party. In simple language, when we deposit money in our bank account, we get interest on it from a bank. Hence, we withdraw more money than we deposited. In this case, a bank is paying interest to us.
Similarly, when we take a loan from a bank, we need to give more money than what we got because the bank takes interest on the principal amount from us. There are different ways to count interest. Interest and profit are not the same terms. We can count interest if we know the amount paid, the period for which the amount is paid, and the interest rate.
The rate of interest is counted by the amount paid in total divided by the original amount borrowed. The rate of interest is expressed by the percentage (%) sign. Interest is a very important topic of mathematics that is widely used in the banking sector.
Here, we will look at Simple Interest and Compound Interest Differences so you do not confuse between the two.
What is Interest?
As we know, interest is money paid regularly at a fixed predefined period for the use of money borrowed or for delaying while repaying our payment. Interest is the fee for using someone else’s money if we simplify it in the commoner’s language. There are two types of interest in normal practice: simple interest and compound interest.
In simple interest, interest is calculated by the normal formula on the original amount borrowed. In compound interest, interest on prior interest paid is applied. Hence in compound interest, you pay more money as it grows exponentially.
Usually, we calculate interest on a daily, monthly, or yearly basis as per requirement. The interest rate highly influences interest. The interest rate varies from organization to organization and person to person based on some pre-decided set of rules of an institution and people involved.
What is a Simple Interest?
Simple interest is the fast and easiest method of calculating interest on the principal amount. As the name suggests, simple interest is calculated on the original amount borrowed or the remaining amount over some time. It is easy to calculate and can be calculated over any period than a year. This means we can count it quarterly, monthly or daily too. It does not have a compound effect of interest. We normally use simple interest in different kinds of loans.
Simple interest can be calculated using the below formula:
R * B * m / n
Where,
r is the normal yearly interest rate
B is the borrowed amount or initial capital balance
m is the period and
n is the number of times interest is to be applied (frequency)
For example, if your principal amount is 5,000$ and the simple interest rate is 10% yearly, here frequency is 12 per year. So, interest per month will be,
(0.10 * 5,000) / 12 = 41.66$
Simple interest for 5 months will be,
(0.10 * 5,000 * 5) / 12 = 208.33$
Which equals the sum of interest you get per month (41.66$ as above) five times.
41.66 + 41.66 + 41.66 + 41.66 + 41.66 = 208.3$
What is a Compound Interest?
If you apply interest on previously earned interest, then this cumulated interest is known as compound interest. In simpler language, simple interest is applied on the principal amount only, while compound interest will be applied on the principal amount plus the cumulative interest from the previous period.
We usually use compound interest while counting the interest of our savings account. It is very different from simple interest, and it needs a different formula to find an interest that serves the purpose.
Compound interest can be calculated using the below formula:
(1 + r/n)n – 1
Where,
r is the normal yearly interest rate
n is the number of times interest is to be applied (frequency)
For example, in the case of a 6% simple yearly interest rate, the annual compound rate will be,
( 1 + 6% / 2)2 – 1 = 1.032 – 1 = 6.09 %
Applications of Simple Interest and Compound Interest
Simple interest is more useful to borrowers and hence mostly used in retailer instalment loans, car loans, home loans, education loans, instalments, etc.
On the other hand, compound interest is more useful to investors and hence mostly used in bank transactions, counting interest of savings accounts, increase and decay in the value of the item, inflation in the profit and loss, increase and decrease in commodity prize, growth and decay in the population, etc.
Difference between Simple Interest and Compound Interest
As we now know the basics about interest, simple interest and compound interest differences are easy to understand. Understanding the differences between simple interest and compound interest will help you save more money than before, boost your net worth over time and take better financial decisions. Some of them are as below-
- Simple interest is calculated on the original amount borrowed, while compound interest is calculated on the original amount plus interest compounded of the period
- Simple interest is easy to calculate, while compound interest is a bit complicated to calculate
- Simple interest pays a smaller amount than compound interest
- The original principal amount stays constant in simple interest while it keeps changing in compound interest
- Growth of simple interest is uniform while the growth of compound interest keeps increasing exponentially
- The interest we get or pay in simple interest is less with compared to interest we get or pay in compound interest
- Simple interest is very helpful when you are a borrower and taking loans. As the loan cost is the same for every payment in simple interest, it saves you money. At the same time, compound interest is very helpful when you are an investor and saving your money in different schemes or funds because growth will be exponential. And compound interest will give you more profit.
Conclusion
In this article, we discussed the meaning of interest, types of interest, applications of simple and compound interest in the real world, and formulas to find simple or compound interest with examples and differences between simple and compound interest.
We are always supposed to choose simple interest if we are borrowers and compound interest when we are investors. We hope you enjoyed this article and got to know everything you wanted to know about interest.