Simple interest and compound interest differ primarily in how interest is calculated over time. Simple interest is calculated only on the original principal amount, without considering any interest previously earned or paid. Compound interest, on the other hand, is calculated on both the principal and the accumulated interest from prior periods, resulting in exponential growth.
Key Differences
- Calculation basis: Simple interest is computed solely on the principal. Compound interest is computed on the principal plus any previously earned interest.
- Growth pattern: Simple interest grows linearly and predictably. Compound interest grows exponentially, accelerating over time.
- Application: Simple interest is commonly used for short-term loans like car loans, personal loans, and some bonds. Compound interest is typical for savings accounts, investments, and credit card balances.
- Financial impact: Compound interest can lead to greater returns on investments due to reinvestment of interest, but also higher borrowing costs since interest is charged on accumulated interest. Simple interest generally results in lower total interest on loans.
Formulas
- Simple interest: Interest=Principal×Rate×Time\text{Interest}=\text{Principal}\times \text{Rate}\times \text{Time}Interest=Principal×Rate×Time
- Compound interest: A=P(1+rn)ntA=P\left(1+\frac{r}{n}\right)^{nt}A=P(1+nr)nt where AAA is the amount, PPP is the principal, rrr is the rate, nnn is the number of compounding periods per year, and ttt is the time in years.
In summary, simple interest is straightforward and calculated on the starting principal alone, while compound interest takes into account interest on interest, leading to faster growth or higher debt depending on context.
