# Simple interest vs compound interest explained

Simple interest is a way of calculating the interest charge on a loan or investment based on the original principal amount and the interest rate. Compound interest, on the other hand, is calculated not just on the initial principal but also on the accumulated interest from previous periods.

Simple interest is better for installment loans, while compound interest is preferable for investment accounts. In fact, the average savings account currently yields about 0.46% annual interest!

## What Is Simple Interest?

Simple interest is the interest rate based on the principal balance of a loan or investment. Suppose you borrow money through a poor credit personal loan and repay through equal monthly installments. Those monthly payments consist of the principal balance and the interest fee.

A standard interest rate does not change over time. This means a borrower always pays the same amount of money for loan payments. An example of a simple interest loan is a debt consolidation loan, which typically has a 7% rate or lower!2

### Pros of Simple Interest

• Borrowers benefit from predictable and often lower total interest payments over the life of a loan.
• Individuals with fixed-income investments receive a steady return over the investment period.

### Cons of Simple Interest

• Savers and investors may earn less over time as interest is not compounded.
• Lenders and financial institutions might receive lower returns on their lending products compared to those with compound interest.

## How To Calculate Simple Interest

To calculate simple interest, you must use the simple interest formula I = (P x R x T). Calculating simple interest is easy, but you need to know the following information:

• I is the interest amount
• P is the principal amount (the initial sum of money)
• R is the annual interest rate (in decimal form)
• T is the time the money is invested or borrowed for (in years)

To find the total amount owed or accumulated after the interest is applied, you simply add the interest (I) to the principal (P). For example, if you invest $1,000 (the principal) at a simple interest rate of 5% per year (0.05 in decimal) for 3 years, the interest would be$1,000 \times 0.05 \times 3 = $150. So, the total amount after 3 years would be$1,150.

## What Is Compound Interest?

Compound interest is a type of interest rate that combines the principal amount with the total accumulated interest. Money can be compounded daily, monthly, or yearly.

Compound interest can be exceedingly beneficial when you invest because you can quickly grow your money. Most savings accounts have compound interest. Compound interest examples include money market accounts and certificates of deposit (CD). Ideally, your financial investment should compound as frequently as possible.

### Pros of Compound Interest

• Savers and investors can significantly increase their savings, especially over long periods.
• Financial institutions offering compound interest products can attract more customers seeking to grow their investments.

### Cons of Compound Interest

• Outstanding debt can grow quickly due to the compounding effect.
• Investors might underestimate the amount of interest to be paid on loans or the growth of investments.

### How To Calculate Compound Interest

The formula for calculating compound interest is: A = P (1 + [r / n]) ^ nt. If you want to calculate compound interest, you will need to know the following information.

• A = The amount of money accumulated after N years, including interest.
• P = Principal amount
• R = Annual rate of interest (as a decimal)
• N = The number of times that interest is compounded per year
• T = How long money is deposited or borrowed (in years)

Here’s how to use the compound interest formula:

1. Divide the annual interest rate by the number of compounding periods per year.
2. Add 1 to the result from step 1.
3. Raise the result from step 2 to the power of the total number of compounding periods (compounding frequency times the number of years).
4. Multiply the principal amount by the result from step 3 to get the total accumulated amount.
5. Subtract the principal from the total accumulated amount to find the compound interest earned.