Simple Interest vs. Compound Interest: An Overview
Interest is the cost of borrowing money, where the borrower pays a fee to the lender for the loan. The interest, typically expressed as a percentage, can be either simple or compounded. Simple interest is based on the principal amount of a loan or deposit. In contrast, compound interest is based on the principal amount and the interest that accumulates on it in every period. Simple interest is calculated only on the principal amount of a loan or deposit, so it is easier to determine than compound interest.
- Interest is the cost of borrowing money, where the borrower pays a fee to the lender for the loan.
- Generally, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent.
- Compound interest accrues and is added to the accumulated interest of previous periods, so borrowers must pay interest on interest as well as principal.
The Difference Between Compounding Interest and Simple Interest
Simple interest is calculated using the following formula:
Simple Interest=P×r×nwhere:P=Principal amountr=Annual interest raten=Term of loan, in years
Generally, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent. For example, say a student obtains a simple-interest loan to pay one year of college tuition, which costs $18,000, and the annual interest rate on the loan is 6%. The student repays the loan over three years. The amount of simple interest paid is:
and the total amount paid is:
Compound interest accrues and is added to the accumulated interest of previous periods; it includes interest on interest, in other words. The formula for compound interest is:
Compound Interest=P×(1+r)t−Pwhere:P=Principal amountr=Annual interest ratet=Number of years interest is applied
It is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods, and then minus the reduction in the principal for that year. With compound interest, borrowers must pay interest on the interest as well as the principal.
Simple Interest vs. Compound Interest Examples
Below are some examples of simple and compound interest.
Suppose you plunk $5,000 into a one-year certificate of deposit (CD) that pays simple interest at 3% per annum. The interest you earn after one year would be $150:
Continuing with the above example, suppose your certificate of deposit is cashable at any time, with interest payable to you on a prorated basis. If you cash the CD after four months, how much would you earn in interest? You would receive $50: $5,000×3%×124
Suppose Bob borrows $500,000 for three years from his rich uncle, who agrees to charge Bob simple interest at 5% annually. How much would Bob have to pay in interest charges every year, and what would his total interest charges be after three years? (Assume the principal amount remains the same throughout the three years, i.e., the full loan amount is repaid after three years.) Bob would have to pay $25,000 in interest charges every year:
or $75,000 in total interest charges after three years:
Continuing with the above example, Bob needs to borrow an additional $500,000 for three years. Unfortunately, his rich uncle is tapped out. So, he takes a loan from the bank at an interest rate of 5% per year compounded annually, with the full loan amount and interest payable after three years. What would be the total interest paid by Bob?
Since compound interest is calculated on the principal and accumulated interest, here's how it adds up:
After Year One, Interest Payable=$25,000,or $500,000 (Loan Principal)×5%×1After Year Two, Interest Payable=$26,250,or $525,000 (Loan Principal + Year One Interest)×5%×1After Year Three, Interest Payable=$27,562.50,or $551,250 Loan Principal + Interest for Years Oneand Two)×5%×1Total Interest Payable After Three Years=$78,812.50,or $25,000+$26,250+$27,562.50
It can also be determined using the compound interest formula from above:
Total Interest Payable After Three Years=$78,812.50,or $500,000 (Loan Principal)×(1+0.05)3−$500,000
This example shows how the formula for compound interest arises from paying interest on interest as well as principal.