Difference Between Simple Interest & Compound Interest

Simple interest is a method of calculating the interest charged on a sum at a given rate and over a specified period. In contrast to compound interest, which adds the interest of previous years’ principal to calculate the next year’s interest, the principal amount in simple interest is always the same.

You will be introduced to the concept of borrowing money and the simple interest derived from lending in this lesson. You’ll also learn about terms like principal, amount, rate of interest, and period. You can calculate simple interest using the simple interest formula using these terms. You know more about this conception in a practical way, do visit cuemath.com.

What is the Compound Interest Formula?

Compound interest accumulates and is added to the accrued interest from previous periods; it is, in other words, interest on interest. The following is how compound interest is calculated: 

Compound Interest formula – P*- P

P=Principal sum

Annual interest rate = r

t=The number of years for which interest is charged.

It is calculated by multiplying the principal amount by one, multiplying the annual interest rate by the number of compound periods, and subtracting the principal reduction for that year. When using compound interest, borrowers must pay interest on the good and the principal.

What is Simple Interest?

If you make a payment on a simple interest loan, do you know where the money goes? The money first goes toward the interest for that month, and the rest goes toward the principal. The interest is paid in full each month, so it never accumulates. Whereas compound interest adds some of the monthly interest back onto the loan, you pay new interest on old interest each month.

Consider a car loan with a $15,000 principal balance and a simple interest rate of 5% per year to understand how simple interest works. If your payment is due on May 1 and you make it on time, the finance company calculates your interest for April. In this case, your 30-day interest is $61.64. However, if you pay on April 21, the finance company will only charge you interest for 20 days in April, lowering your interest payment to $41.09, a $20 savings.

What Loans Make Use of Simple Interest?

Most banks now use compound interest on loans because it allows them to collect more money as interest from their customers, but this method is more complex and difficult to explain to customers. On the other hand, calculations become simple when banks use simple interest methods. Simple interest is very useful when a customer needs a loan for a short period, one month, two months, or six months.

Simple Interest Vs. Compound Interest

Simple vs. Compound Interest Interest can be simple or compounded. Simple interest is calculated on the loan or deposit’s original principal amount.

On the other hand, compound interest is calculated by combining the principal amount and the interest that accrues on it over time. Simple interest formula is easier to calculate than compound interest formula because it is computed only on the principal.

In real life, compound interest is frequently a factor in business transactions, investments, and financial products intended to last for several months or years. In daily life, simple interest is primarily used for simple calculations, such as those for a single period or less than one year. Simple interest also applies to long-term situations like credit card balances.

Key Takeaways

1. Simple interest is calculated by multiplying the daily interest rate by the principal and then by the number of days between payments, that is, the period.

2. Consumers who pay their loans on time or early each month benefit from simple interest.

3. Auto loans and short-term personal loans are typically interest-only loans.

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