Explain the difference between simple interest and compound interest

By Izzy M
Modified on May 12, 2023
explain the difference between simple interest and compound interest

It’s essential for people to know the differences between simple and compound interest. Interest is a percentage of the loan amount that is paid recurrently. If you lend, borrow, or invest money, it’s critical that you learn how to calculate interest rates. Understanding how simple and compound interest rates work can help you make a well-informed financial decision and manage your finances. 

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 installment loan. In that case, you must repay the loan in equal installments every month for a specified period. 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 retailer installment loan. 

How To Calculate Simple Interest

To calculate simple interest, you must use the simple interest formula (P x R x T). Calculating simple interest is easy, but you need a few pieces of vital information. You need to know the principal amount of the loan, interest rate, and period of time. 

Step 1: Organize Your Data

Before calculating simple interest, you need to organize your data. Ensure you know the exact number for your principal amount. If you are approved for a $2,000 personal loan, the principal amount is $2,000. 

You will also have to convert the interest rate to a decimal. You can do this by placing a decimal two spaces to the left of the percentage. For example, if the interest rate is 20%, the decimal expression is 0.20. 

Step 2: Check the Time Frame

To accurately calculate the simple interest, the interest rate and time frame have to use the same unit of measurement. If the interest rate is an annual percentage rate, the time frame should be years instead of months. 

Step 3: Multiply Your Variables

Once you have your data organized, you can multiply the principal amount by the decimal interest rate and the time. A $2,000 loan with an APR rate of 20% over one year would equal $400 in interest fees. 

What Is Compound Interest? 

Compound interest is a type of interest 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. 

However, compound interest can be detrimental to your finances if you borrow money. If you take out a compound interest loan, ensure that interest is compounded infrequently. Simple interest is preferable when you borrow money because you are not paying interest on interest. 

How To Calculate Compound Interest

To determine how much money you will receive or pay, you can use the following formula to calculate the compound interest: A = P (1 + [r / n]) ^ nt.  Financial institutions that have compound interest loans or savings accounts charge interest on the principal and accumulated interest.  

Step 1: Organize Your Data

The compound interest formula uses more variables than the simple interest formula. However, it is still relatively easy to calculate compound interest. You need to know the following information to accurately calculate the total amount (A) of compound interest:

  • P = Principal amount
  • R = Annual rate of interest (as a decimal)
  • N = The amount of time interest is compounded per year
  • T = How long money is deposited or borrowed (in years)

Step 2: Convert Your Variables

Before you can calculate the Compound interest, you need to convert the annual rate of interest to a decimal. Suppose your savings account earns a 3% rate of interest. The decimal expression would be 0.03 when you divide the percent by 100. 

Step 3: Multiply Your Variables

Once you have your necessary data, you can plug in each variable to get the total amount of compound interest. Let’s say you put $4,000 into a savings account that pays a 4% interest rate. Your savings account compounds interest monthly, and you don’t touch your money for 2 years. 

Your compound interest variables will look like this:

  • P = $4,000
  • R = 0.04
  • N = 12
  • T = 2

When you use the formula, the total amount of money in your savings account after 2 years would be $4,332.57. From your initial investment of $4,000, you would earn $332.57 in interest. 

If you plan on making additional deposits to your savings account, the calculation can be tricky. Luckily, there are plenty of compound interest calculators online that allow you to input the frequency and amount of deposits or withdrawals. 

Simple Interest vs. Compound Interest 

Simple interest and compound interest differ significantly. You may ask, “Should I get an account with simple or compound interest?” The answer depends on whether you plan on saving or borrowing money. 

There are a lot of pros to having a savings account. You can keep your money secure and earn interest on your deposit. If you invest or save your money, you should look for a financial account that offers compound interest. Compound interest accrues to both the principal balance and the accumulated interest. Money can be compounded daily, monthly, or yearly. A frequent compound schedule can help you earn faster returns on your invested money. 

If you want to apply for a fast cash loan, look for an option that uses simple interest. There are plenty of low interest personal loans for bad credit that do not compound interest. Loans with compound interest work against you because you will end up paying more than you should in interest fees. 

If you end up stuck with a loan that compounds interest, you can take steps to protect your finances. Start working on aggressively paying down your account balance. The quicker you pay down your debt, the less money you will pay in interest fees. You can also try refinancing to get a simple interest loan. Refinancing means replacing an existing debt with another that has different repayment terms. 

Now that you know how to calculate simple and compound interest, you can accurately calculate how much money you will pay or earn. You can use this information to better manage your finances and plan future expenses.

What Is Simple Interest?
Understanding Compound Interest
The Life-Changing Magic Of Compound Interest

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