A significant part of a common man’s life in today’s world revolves around receiving or paying interest. Not only are businessmen greatly involved in this but also other people, for instance, who take loans from Banks or other Financial Institutions. So, interest refers to the cost of borrowing money.
To be able to determine what is in the best interest of any person receiving or paying any kind of interest, one needs to have a knowledge of the different types of interests that are there and how they are the different from each other.
Simple vs Compound Interest
The main difference between Simple and Compound Interest is that Simple Interest is simply calculated on the basis of the principal amount. In other words, Interest on the principal amount for the entire time period is called simple interest. Compound Interest, on the other hand, is calculated on the basis of the principal amount along with interest on the accumulated interest from periods.
Comparison Table Between Simple and Compound Interest (in Tabular Form)
| Parameter of Comparison | Simple Interest | Compound Interest |
|---|---|---|
| Definition | It is the interest paid on only the principal amount of a loan or an account. | It is the interest computed on the principal amount which includes all the accumulated interests of the previous period on a loan or an account. |
| Change in Principal | The principal does not change in case of simple interest. | The principal undergoes a continuous change during the entire borrowing period. |
| Base of calculating Interest | Interest is strictly calculated on the initial principal. | Interest is calculated on the initial principal for the first period and thereafter on a summation of the initial principal and accumulate interest. |
| Growth | The growth remains uniform and steady. | The growth sees a substantial increase. |
| Returns | The returns are constant and comparatively low. | The returns are dynamic and comparatively higher than simple interest. |
| Formula | Amount=P*(1+RT), where P= Principal, R= Rate of Interest and T= Time Period | Amount=P*(1+R)^N, where P= Principal, R= Rate of Return, N= Number of Periods |
What is Simple Interest?
Simple interest is the interest that is charged in the form of a percentage of the initial principal amount, in case of a Loan, Fixed deposit, Savings Account, etc, for the whole period, generally taken to be broken up in one year each.
Simple
interest is the easiest and the fastest method to calculate the interest on a
particular amount. It does not include interest calculated on previous
accumulate interest and only has the initial principal as the basis.
It
has better use while taking a loan as the borrower will only have to pay a
fixed amount as interest, while it may not be able to create wealth, i.e., earn
enough for savings or investments.
In
other words, it is greatly beneficial for the borrower but the lender is at a
loss as the borrower needs to pay less and therefore the lender earns less.
It
is calculated by multiplying the Principal amount with the rate of interest and
the time period and dividing the entire amount by 100.
What is Compound Interest?
Compound
interest is interest calculated on the initial principal, including interest in
the accumulated interests from previous time periods.
The rate of compound interest generated directly depends on the number of compounding periods. In other words, the higher the compounding period, the higher is the compound interest accrued.
It
is a complicated method of calculating interest on a specific amount since it
also takes into consideration the previously accrued interest in addition to
the principal amount.
It has an opposite effect from that of simple interest in the sense that it is more beneficial for the lender than the borrower. This is because the borrower has to pay more interest due to the addition of interest on previously accumulated interests and hence the lender earns more.
It
is calculated by multiplying the principal with one plus the rate of interest,
raised to the power of the number of periods. Finally, the principal amount is
deducted to figure out the interest for the specific period.
Main Differences Between Simple and Compound Interest
It is believed that to understand the difference between technical-sounding terms like Simple Interest and Compound Interest is difficult and that it suits only the analysts and businessmen, however, that is not so. These differences are simple to configure and easier to understand by any person.
- When the interest is charged on the initial principal amount for the entire term, it is known as Simple Interest, whereas, when this interest also includes the interest on the accumulated interests of previous periods, it comes to be known as Compound Interest.
- Compound Interest gives a higher return as compared to the Simple Interest, precisely because of the inclusion of the previous periods’ profits.
- The principal does not undergo any change in case of Simple Interest but the principal keeps on changing in the case of Compound Interest since it includes interest on interests of previous periods.
- With respect to the calculation of Simple and Compound Interest, Simple interest is comparatively easy to calculate than its Compound counterpart.
- Last, but not the least, both of them have opposite effects on the borrowers and the lenders. Borrowers are benefitted by Simple Interest whereas the lenders are benefitted by Compound Interest. Simple interest leads to a downfall in the earnings of the lenders. Compound Interest, on the other hand, increases their earning but also increases the burden on the borrowers.
Conclusion
Interest
is that significant part of our life which we will have to come across
definitely at some point and thus, rather than running away from its
complexities, it will be more beneficial to understand it in its simpler sense.
Understanding the working and the differences between simple and compound interest and how and whom they benefit is not really very complicated, provided a sincere effort is made.
Therefore, consider every investing or borrowing activity very carefully and understand and comprehend the benefits that will accrue to you with respect to the interest policy followed to make the best of everything.
References
- https://commons.allard.ubc.ca/cgi/viewcontent.cgi?article=1001&context=fac_pubs
- https://www.cairn.info/revue-politique-europeenne-2004-2-page-115.htm
- https://journals.aps.org/prb/abstract/10.1103/PhysRevB.70.195106
- https://dl.acm.org/doi/abs/10.1145/1029632.1029639