What is the difference between simple and compound interest

Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Interest is the cost of borrowing money, where the borrower pays a fee to the lender for the loan.

The interest, typically expressed as a percentage, can be either simple or compounded. Simple interest is based on the principal amount of a loan or deposit. In contrast, compound interest is based on the principal amount and the interest that accumulates on it in every period. Simple interest is calculated only on the principal amount of a loan or deposit, so it is easier to determine than compound interest. Simple interest is calculated using the following formula:. Generally, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent.

The student repays the loan over three years. The amount of simple interest paid is:. Compound interest accrues and is added to the accumulated interest of previous periods; it includes interest on interest, in other words. The formula for compound interest is:. It is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods, and then minus the reduction in the principal for that year. Also, compound interest is used by fixed deposits , mutual funds, and any other investment that has reinvestment of profits.

CI is calculated by multiplying one plus interest raised to the power of the compounding periods with the principal amount. Finally, the principal amount has to be subtracted to obtain the CI. One can use the following formula to calculate compound interest :. One can compute the CI using the formula.

The corpus at the end of his investment tenure is INR 16, the principal and the interest. On the other hand, the simple interest for the same investment and tenure is INR 5, If the frequency of compounding is higher, then the interest will be higher. Also, if the investment duration is higher, the returns will be higher as well. Compounded — half yearly, therefore the compounding periods are 2. Mr Charan earned INR extra in this case.

Hence with higher compounding periods, the interest will also be higher. Compounding refers to a scenario where interest earns interest. It simply means when earnings are reinvested, the initial investment and the reinvested earnings grow at a constant rate.

This makes the investments multiply at a faster rate. This is called the power of compounding. The higher the compounding frequency, the higher will be the returns from the investment. Compounding frequency is the number of times the interest is calculated in a year. Compounding is a compelling concept, and no wonder Albert Einstein called it the 8 th wonder of the world.

Under compounding , you can make your money work harder for you. The interest that accumulates earns more interest in the long term. Also, the longer you stay invested, the higher will be the return from an investment. Hence it is advisable to start investing at early ages to benefit from the power of compounding. Following are the key differences between simple interest vs compound interest:. Last updated November 10, Our weekly newsletter with finance tips and investment insights from our experts.

Your privacy is important to us. Share this article. Article Content. What is a Simple Interest? What is the formula for Simple interest? What is compound interest? The compound annual growth rate CAGR is used for most financial applications that require the calculation of a single growth rate over a period. CAGR is extensively used to calculate returns over periods for stocks, mutual funds, and investment portfolios.

CAGR can also be used to calculate the expected growth rate of investment portfolios over long periods, which is useful for such purposes as saving for retirement. Consider the following examples:. Make sure you know the exact annual payment rate APR on your loan since the method of calculation and number of compounding periods can have an impact on your monthly payments.

While banks and financial institutions have standardized methods to calculate interest payable on mortgages and other loans, the calculations may differ slightly from one country to the next. Compounding can work in your favor when it comes to your investments, but it can also work for you when making loan repayments.

For example, making half your mortgage payment twice a month, rather than making the full payment once a month, will end up cutting down your amortization period and saving you a substantial amount of interest. Compounding can work against you if you carry loans with very high rates of interest, like credit card or department store debt. Get the magic of compounding working for you by investing regularly and increasing the frequency of your loan repayments.

Familiarizing yourself with the basic concepts of simple interest and compound interest will help you make better financial decisions, saving you thousands of dollars and boosting your net worth over time. Interest Rates. Technical Analysis Basic Education. Tools for Fundamental Analysis. Savings Accounts. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.

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