Difference Between Simple Interest and Compound Interest: In a financial situation where you have to borrow money from acquaintances or take a loan from a bank or make investments, you would be required to pay an additional amount of money. That extra amount is like a “thank you” fee to the lender for lending you that amount. The scholarly term for that additional sum is called an Interest.
When it comes to investments, however, the extra money paid to the lender who invested is also referred to as Interest.
Interest is defined as the percentage of the original loan amount which is to be added to that loan amount that is to be repaid over a particular period. It is the cost of borrowing money from a person or firm where the borrower pays a fee to the lender for a loan as a privilege for using their money.
An example is a scenario where You will be credited if the client deposits money in the bank and leaves it for some time. The borrower is the bank in the issue, whereas the lender is the one that holds the money being deposited. The bank invests the funds to create a profit, which is then used to pay interest to their customers.
Hence we can say that what it takes to borrow money is more money. The most common forms of interest are simple interest and compound interest which are dependent on the tax considerations, credit risk, time, and convertibility of the particular loan. It is important to remember that interest and profit are not the same things, even if they are related.
The distinction is that interest is paid by the lender, who may or may not be the owner of the business, whereas profit is paid by the asset or business owner. As we distinguish between simple and compound interest, this may be useful in deciding which sort of interest to pursue while investing or taking out a loan.
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What Is Simple Interest?
Simple interest is just the principal amount of a loan or deposit made into a person’s bank account. It is a predetermined percentage of the borrowed principal amount. Simple interest does not take preceding interest into account. It is based only on the initial donation amount. Borrowers win from simple interest, whereas investors suffer since they must pay interest solely on loans accepted because there is no compounding power. Simple interest is readily calculated by multiplying the interest amount by the tenure and the principal proportion.
How To Calculate Simple Interest
Simple interest is calculated mathematically by multiplying the principal by the rate of interest for some time and the tenure which may be in days, weeks, months, and even years. Hence the interests rate has to be converted accurately before multiplying with the principal amount and tenure.
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Simple Interest = principal x Interest Rate x Time
I = (P *R * T) / 100
I = Simple Interest
P = principal amount which is the original sum of money
R = Rate of interest for some time in percentage.
T = Time Interval
For instance, You take out a loan for #40,000 from a private company that offers three-year repayment terms. A basic interest rate of 2% is charged by the company. It’s a set proportion that isn’t going to alter.
To figure out how much simple interest you owe, use the following formula:
I = (2,400 x 2 x 3) / 100 I = (P x R x T) / 100 I= (40,000 x 2 x 3) / 100
As a result, you must pay a total of $2,400 in simple interest over three years.
Examples of simple Interests are:
Car loans: Because a car is regarded as a liability, their loans depreciate regularly, suggesting that the interest payable reduces as the outstanding loan balance lowers each month, implying that a bigger percentage of the monthly payment is applied to the principle.
Discounts on early payment: Suppliers frequently give a discount to promote the early payment of bills in the business sector. This is a very appealing arrangement for the payer. For example, a $50,000 invoice may offer a 0.5% discount for payment within a month. This works out to $250 for early payment. Certificates of deposit (a bank investment that pays out a certain amount of money on a predetermined date) and so on.
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What Is Compound Interest
Compound interest is a sort of interest that builds up and compounds over time. It’s a percentage of the principal amount, plus any interest that has already accumulated. It’s also possible to call it Interest on Interest. The whole premise is based on compounding the interest obtained on the original sum to generate substantial returns. The higher the compounding frequency, the bigger the interest accrual amount. As a result, investors profit more than borrowers from compound interest.
Compound interest is the most prevalent type of interest.
Fixed deposits, mutual funds, student loans, and investments all utilize this term. Compound interest is also used by banks when making loans.
How To Calculate Compound Interest
For one to be able to calculate compound interest there are some questions to be considered; How much money do you have to begin with? What was the total amount of money you borrowed? How long do you expect to hold a bank account or repay a loan? Do you intend to make frequent deposits into your account? How frequently will you repay your loan?
This is because compounding is dependent on the amount you own or borrow, and the longer you keep money in an account or keep a loan open, the longer it takes to compound. The rate at which interest is compounded, as well as how you accumulate or pay off your principal, affect how quickly you accumulate or pay off your debt.
Compound interest is calculated using the principal and interest earned over some time.
Compound Interest = Amount — Principal
Amount = P(1+r/n)^(n x t)
P = Principal Amount
r = Interest rate converted to decimal
n = Number of compounding periods
t = Time Interval in years
COMPOUND INTEREST= P[(1+r/n)^(n x t)] —P
For interest compounded once per period, the Amount A is:
A = P(1+ R/100)^t
A = Amount compounded annually
R = Rate of interest in percentage
t = Number of times interest is compounded
For example, if you have $2,000 in your savings account and get 5% interest every year. Your balance would be #2100 after the first year, with an interest rate of #100. The balance of #2100, which became the new primary at the beginning of the second year, would yield you 5% after the second year. After the second year, the interest becomes #105, and the total amount is $2205. As a result, two years later, the compound interest is #2205 — #2000 =#205.
Difference Between Simple Interest and Compound Interest
Simple interest and compound interest can be distinguished as follows:
1. Since simple interest is calculated as a percentage of the principle, the amount is always the same. Because compound interest is a proportion of the principal plus interest earned or accumulated to date, it varies from accrual period to accrual period.
2. With simple interest, the principle does not change. Compound interest is calculated by adding the compounded interest to the principal, increasing the principal.
3. Simple interest is more straightforward to compute. The compound interest calculation contains a lot of variables to consider, and it’s a bit complicated.
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4. In comparison to compound interest, simple interest yields lower returns.
5. When you borrow money for items like auto loans, simple interest works to your advantage because the cost of the loan is the same for each installment. Compound interest is preferable to simple interest when investing or saving since your money will increase faster.
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Since compound interest rather than simple interest might result in a significant variation in the amount of interest payable on a loan, Learning the fundamentals of simple and compound interest can help you make smarter financial decisions, perhaps saving you thousands of naira and increasing your net worth over time through investments.
Edeh Samuel Chukwuemeka, ACMC, is a lawyer and a certified mediator/conciliator in Nigeria. He is also a developer with knowledge in various programming languages. Samuel is determined to leverage his skills in technology, SEO, and legal practice to revolutionize the legal profession worldwide by creating web and mobile applications that simplify legal research. Sam is also passionate about educating and providing valuable information to people.