What Is The Difference Between Simple Interest And Compound Interest?
Whenever you borrow, you should always know exactly how much you will have to repay.
Borrowers universally wish to access financing at a lower rate, whether it is for a mortgage or renovation.
Lenders, conversely, prefer higher rates given they provide the chance to earn more from financing.
Interest can be broken down into simple and compound interest, which can change the calculation significantly.
Due to the nuances, it is common for people to get confused between them.
Accordingly, keep reading to explore the differences between simple and compound interest with some helpful examples.
What Is Interest?
When you borrow money from a lender, you need to compensate them for the risk they are taking over a specified period of time.
This compensation takes the form of the interest rate for the loan amount.
The rate is always expressed in percentage form and can be either simple or compounded.
With simple interest, you only pay interest based on the principal amount you borrowed.
However, with compounding, you will have to pay based on the principal amount, along with the interest that gets accumulated with each payment.
Read on to study both in greater detail.
The basic simple interest definition is that simple interest, during a loan term, is a fixed percentage of the principal amount that you borrowed.
You can calculate it based on the following formula.
Simple Interest= P (principal amount) x r (rate) x n (loan term in years).
Let us assume that you took out an installment loan of $15,000 at 5% for three years. You can calculate the amount as follows.
15,000 (P) x 0.05 (R) x 3 (n) = 2,250 (SI).
The total amount you would need to pay over the life of the loan would be, $15,000 (total principal) + $2,250 (total interest)= $17,250.
Unlike simple interest, compound interest is accrued, and the amount is ultimately added to the accumulated interest.
In other words, we can also call it interest on interest.
Unlike simple interest, you will have to pay interest on interest in addition to the principal amount.
The formula to calculate the compound interest rate is as follows.
CI= P x (1+r)t – P
P= Principal amount
r= Annual lending rate
t= Number of years
Let us assume that you borrow a personal installment loan of $400,000 at 5%. You will have to pay $20,000 ($400,000 x 5% x 1) as interest each year.
At the end of the second year, the interest payable would be $21,000 ($420,000 loan principal plus one year interest amount x 5% x 1).
At the end of the third year, the interest payable would be $22,050 ($441,000 loan principal plus interest amount of year one and two x 5% x 1).
Comparing The Two
As highlighted by the aforementioned examples, it is easier to understand and calculate simple interest.
When you borrow a loan with a simple interest rate, you will only need to keep in mind the interest accumulated on the outstanding principal amount.
Most mortgages and car loans use this simple interest formula.
However, if you want to invest in something, the compound interest rate would be much better given the opportunity to accumulate interest on the total amount.
As a borrower facing compound interest, it is always wise to get rid of the interest sum on the loan first. You can then pay off the principal sum.
This will help you clear the debt quickly given that payable interest will not keep compounding and enlarging the total.
Other Interest Considerations
Different lenders have distinct ways of calculating the interest rate.
The number of compounding periods and annual payment rates (APR) is very important because they directly affect your monthly payments.
Compounding usually works when you have an investment, but it can also work when you repay a debt, especially credit cards.
To offset this, instead of making your full payment once a month, you can try to repay every two weeks, amounting to 26 payments annually instead of 12.
This will reduce any amortization period, especially for car and home loans, helping you save money on the interest amount.
Simple interest is easy to understand and calculate given its straightforward nature.
Compounding, on the other hand, is a little more complex and difficult to calculate.
However, it can benefit you, especially in the investing framework, if you understand it well.
When you invest regularly or increase the frequency of your loan repayments, you can enjoy the benefits of compounding.
To make better financial decisions, it is important to understand both concepts.
It will help you save a lot over the long run, which will ultimately benefit your wallet most.