Simple vs. Compound Interest: Definition and Formulas

If you are getting a debt from a bank that charges you 7% of simple interest, how much interest are you paying for Rs. 10,000 in a period of 3 years? Are you wondering what simple interest is? On the other hand, if you have an investment in mutual funds that has been earning 12% compounded interest for the past five years, how much interest have you earned? Once again, are you wondering what compound interest is? This post is here to seek out these kinds of questions in your head. Are you ready to take this interesting journey?

What is Simple Interest?

Simple interest is a straightforward method of calculating interest on loans or investments. It is based on the principal amount of the loan or investment and the rate of interest charged. As we proceed, we can understand how to calculate simple interest.

What is Compound Interest?

Compound interest is a way of calculating interest on a loan or investment in which the interest is applied to both the initial principal and accumulated interest from previous periods.

This means that over time, interest earns interest, which will, in turn, lead to exponential growth in the value of the investment or debt. Sounds like more math, right? Just look for a compound interest calculator. It is simple to use and does all the math for you.

How to Calculate Simple and Compound Interest?

	Simple Interest	Compound Interest
The Formula	Simple Interest=Principal×Rate×Time	A=P×(1+ n/r) nt
Formula Explained	Principal Interest: It is the initial amount of money that has been lent or invested. Rate/Percentage: This is the annual rate of interest charged. Tenure: This is the time period for which the money is borrowed or invested, and it is typically in years.	A: It is the future value of the investments/loan, and it includes interest. P: It is the principal amount. r: It is the annual interest rate. n: It is the number of times interest is compounded for a unit of time. t: It is the money invested or borrowed for years.
Uses	Simple interest is often used in situations where the interest is not compounded, it is not added to the principal amount, and the subsequent interest is not calculated according to the cumulative amount. It is basically used for short term loans and certain investments.	Compound interest is broadly utilized in various financial instruments like savings accounts, certificates of deposits, investments, and mortgages. It is beneficial for an investor since it allows him to grow financially over time. However, for a borrower, it could lead to accumulated debt when not managed carefully.

The Major Benefits of Simple Interest

Simple interest offers various benefits, and they are:

Easy to Calculate: Simple interest is much easier to calculate than compound interest; you do not have to use a calculator or seek help to get this job done.
It is Transparent: Simple interest is much more transparent, and you will know the aftermath beforehand.
It is Predictable: It is a predictable form of interest, and you will know beforehand what you are going to pay or receive through this form of interest charges.
Better Choice for Borrowers: Borrowers can keep account of what they have been lent and how much they will pay after the tenure is completed. It is a much lesser form of interest than compound interest since it is only charged on the principal amount.
Better for Loans: If you are getting a loan, getting a loan with simple interest is a much better option than compound interest since it is less.

The Major Benefits of Compound Interest

Compound interest too poses various sets of benefits, and they are:

Exponential Growth for Investors: Investors can grow abundantly through compound interest options. It is a much richer option to choose than simple interest since it will compound over the interest earned previously.
Wealth Accumulation Happens Faster: Compound interest investments allow investors to accumulate wealth faster than simple interest. This helps the investor build wealth and grow financially over a span of time.
Passive Income Generation Source: Apart from earning salaries or working for your money, having your money work for you and earning passively can happen effortlessly through compound interest options.
It is a Hedge Against Inflation: Inflation happens every year, especially in a developing country like India. What option can give you financial stability through inflation? Compound interest. It can be a hedge against inflation in a broad perspective. Therefore, your investments in compounding tools can help you prosper even with inflation.
Reinvestment Options: You can use the compound interest funds of your investment to invest in various other tools of investments. This will help you grow your funds on a larger scale than you imagined.
Long-Term Planning Choice: Compounding investments help you plan for the future and set your finances properly for retirement, future investment and much more.

Both forms of interest rates are a good source for your finances. When you are faced with simple interest, it can help you with lower debt burdens. When you find the options of compound interest, it is a better choice for your investments and growing wealth.

Conclusion

Now that you know enough about simple and compound interest – you can understand your finances better. Now, you would choose investments that give you compound interest options, and you would choose simple interest in case of debts. Apart from that, you would always look out for compounding investment tools for better financial well-being.