Simple Interest Vs Compound Interest

Simple interest refers to the interest which is calculated on the principal amount that is borrowed or invested by the person. In contrast, compound interest is the interest calculated on the principal amount borrowed or invested by the person along with the previous period's accumulated interests.

Interest is the fees paid by the borrower to the lender for borrowing money. For example, banks charge interest on the loans taken by the customers. People deposit money in the banks to earn interest on the amount deposited. Higher interest rates are the opportunity for investors to earn higher rates of return.

Simple Interest vs compound interest is a topic that compares two very important and widely used financial concepts that help in calculating the interests on borrowed amount. Banks and financial institutions lend money to individuals and corporates for various purposes like buying property, car, or any other asset, investment in infrastructure projects, expansion of business, buying advanced machinery and so on.

There are two ways to calculate the interest on the principle: Compound and Simple interest.

Simple interest is very straightforward method in which the interest on loan is calculated on the loan amount. But the amount calculated as interest is fixed or remains the same throughout the term of the loan.  Thus, in this case, since the interest does not get added to the principal, the amount is constant.

The method of compound interest is a more complex way of calculating the interest on a loan borrowed. In this method, the calculation considers both the principal and the interest amount accumulated over the past years. Therefore, this is profitable for the lenders since they can earn on both the principal amount and previously made interest. The simple interest vs compound interest graph will also show the method in an easy and simple way. In this article, we will learn about the two concepts through a simple interest vs compound interest comparison chart, which will help us better understand.

Simple interest, as the name suggests, is simple in the calculation and understanding. It is the amount that the lender charges the borrower on only the principal loan.

The formula to Calculate Simple Interest is:

Where SI is Simple Interest

• P is Principal
• R is the rate
• And T is the time for which the loan is given.

The amount owed at the end of the period is given by

A = SI + P or A = PRT/100 + P

Compound interest is earned on the principal amount and the accrued interest. Compound interest depends on the frequency of compounding, i.e., the interest can be compounded daily, monthly, quarterly, half-yearly or annual, etc.

The formula to calculate the amount earned when the principal is compounded is given as:

Where A is the Amount,

• P is the principal,
• R is the rate of interest.
• T is the time for which the principal is owed

Thus, the Compound Interest is calculated = A – P = P (1 + r/100)^T – P

It can be equal to or more than the simple interest depending on the time and frequency of compounding.

The infographics given below is like a simple interest vs compound interest comparison chart which shows the differences is a concise and systematic format. It helps the reader to interpret and remember the points easily. Let's see the top differences between simple vs. compound interest.

Let us understand both the concepts with the help of some suitable examples which will explain the process along with also simple interest vs compound interest formula.

Example #1

Consider a person XYZ who keeps $ 1000 in a bank for one year at a 5% interest rate. Calculate the Simple and compound interest (compounded annually).

Simple Interest = P * R * T/100

• SI = 1000 * 5 * 1/100
• SI = $ 50

Compound Interest = P (1 + r/100)^T – P

• CI = 1000 (1 + 5/100)¹ – 1000
• CI = $ 50

The interest is equal since the interest is compounded annually, and the deposit duration is 1.

Example #2

Let's consider the same example and change the duration to 2 years.

Simple Interest = P * R * T/100

• SI = 1000 * 5 * 2/100
• SI = $ 100

Compound Interest = P (1 + r/100)^T – P

• CI = 1000 (1 + 5/100)² – 1000
• CI = 1102.5 – 1000 = $ 102.5

Thus, with the change in the deposit duration, the interest earned has increased by $ 2.5. This, $ 2.5, is the interest earned on the interest accumulated in the first year of the deposit.

From the above examples, we get a clarity on the calculation of simple interest vs compound interest loan, be it for corporate or individual purpose.

The key difference section given below highlights the important point of differences between the two topics with a lot of clarity and details. Let us study them and understand the two concepts clearly. Key Differences simple interest vs compound interest formula are as follows -

• Simple interest is interest only on the principal, whereas compound interest is the interest earned on the principal and the subsequent interest accumulated over the period.
• The principal amount remains the same in simple interest, whereas the principal amount changes as the interest accumulates over time.
• Simple interest does not depend on the frequency of the interest calculation, whereas compound interest depends on the frequency; the compound interest is higher when the frequency increases.
• Compound interest is always higher than or equal (only if compounded annually and for a term of 1 year) to the simple interest.
• As per the simple interest vs compound interest graph, simple interest has lesser returns to the investor than compound interest.
• Wealth creation is more when the principal is compounded than when simple interest is used.
• The final amount after the period ends in a simple interest is given by P (1 + RT/100), whereas the final amount in Compound interest is P (1 + r/100)^T
• The interest earned when it is simple interest is calculated as P * R * T/100, whereas when the interest is compound, the interest earned is P ((1 + r/100)^T – 1).

The comparative table below shows the differences in a tabular format points out simple interest vs compound interest loan on the basis of their definition, interest earned, return on principal, formula of both, calculation, etc.  

This has been a guide to what is Simple Interest Vs Compound Interest. We explain each of them along with video, examples, infographics & key differences. You may also have a look at the following articles –

• Compound Journal Entry
• What is Accrued Interest?
• Calculate Interest Income
• Imputed Interest