What Is the Difference Between Simple vs. Compound Interest?
By Indeed Editorial Team
Published November 5, 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
In finance and accounting, interest is a percentage of a loan or deposit added to the initial amount for repayment. While there are various types of interests, simple interest and compound interest are the most common. Learning the differences can help you make better financial decisions and increase your net income over time. In this article, we outline the differences between simple vs. compound interest, show how to calculate both terms, provide several examples, and discuss tips for performing accurate calculations.
Differences between simple vs. compound interest
While you calculate simple interest based only on the principal amount, compound interest depends on the principal amount and its accumulated interests. Here are the differences between simple vs. compound interest:
Simple interest is easier to calculate than compound interest, which involves more variables.
When calculating simple interests over a period, the amount remains constant. In comparison, the amount changes when calculating compound interest because it's a percentage of the initial amount and accrued interests.
As the interest rate and principal amount are constant with a simple interest loan or deposit, outstanding interests may not apply. In comparison, you may pay or receive outstanding interests with compound interest calculations.
Simple interest is favourable if you need a loan to purchase an item, such as a car, because the loan's cost remains the same. In contrast, compound interest is ideal for investing or saving your money because you can expect to earn more interest over time.
How to calculate simple interests
Follow these steps to calculate the simple interest on a loan or deposit:
1. Find the principal amount (p)
Start by identifying the initial amount of the loan or deposit. If you're performing calculations for an organization, you can find this information by collaborating with accounting and finance professionals. The principal is typically a dollar value.
2. Determine the applicable rate (r)
The rate is a proportion of the principal you can expect to receive or repay regularly. It's typically in percentage per period. For example, you may have a 4% annual interest rate on your mortgage.
3. Identify repayment period (t)
The repayment period refers to the duration you can expect to fully repay a loan or receive your total amount. It may be in days, months, quarters, or years. Ensure the interest rate (r) and loan or deposit term (t) are in the same timeframe. For example, if the repayment duration is 72 months, check that the rate is also in months.
4. Use the simple interest formula
Multiply the principal amount (p), interest rate (r), and repayment period (t). The result you get is the simple interest. Here's the formula for calculating this type of interest:
Simple interest (I) = principal amount (p) x rate (r) x repayment period (t)
Simple interest examples
Review the following examples of how to calculate simple interest:
Simple interest example for a borrower
This example shows how to calculate simple interest for an individual who received a loan:
James borrowed $5,000 from a bank to repay over five years. The bank charges an interest rate of 2.8% per year and agrees to keep this rate fixed. James uses the simple interest formula to find how much he owes aside from the initial loan amount. After performing his calculations, he discovers that he would pay $5,000 x 0.028 x 5, which is $700 in simple interest over the next five years. The bank allows him to pay a regular interest of $700 / 5 every year, which results in $140 per year.
Simple interest example for an investor
This example shows how to calculate simple interest for an individual who invested money into a scheme:
Martha deposited $1,000 into a savings account. The bank offers 2.8% simple interest every month to customers who have a savings account. After 15 years, Martha decides to withdraw her initial amount and interest. She finds that the bank paid a simple interest of $1,000 x 0.028 x 12, which results in $336 per year. Over 15 years, she received $366 x 15, which resulted in $5,040 in simple interest. Her total withdrawal amount would be $5,040 + $1,000, which results in $6,040.
How to calculate compound interests
Follow these steps to find the compound interest on a loan or deposit:
1. Determine the variables
To find compound interests, you'd need the principal amount (p), interest rate (r), and compounding period (t). A compound period is a time from the start of interest accumulation. By increasing this period, you can expect to increase the compound interest.
2. Apply the compound interest formula
Next, add one to the interest rate (r) and find the sum's exponent to the number of compounding periods (t). Subtract the result you obtain from one, then multiply the value by the principal amount (p). Here's the formula for compound interest:
Compound interest (CI) = Principal (p) x [1+interest rate (r) ^ compounding periods (t) -1]
3. Find the compound interest for other periods
Use the compound interest formula for other timeframes. By changing only the compounding period, you can obtain the compound interest for the subsequent days, months, or years. You can also add the compound interest to the principal amount to find the compound amount. Here's the formula for this calculation:
Compound amount (A) = principal amount (p) + compound interest (CI)
Compound interest examples
Review these examples of how to calculate compound interests:
Compound interest example for a borrower
This example shows how to calculate the compound interest for an individual who applied for a loan:
Sarah recently opened a bakery. To fund her costs, she took a three-year loan of $5,000 from a financial institution and agreed to repay at a 5% compounded interest per year. At the end of the loan period, she applies the compound interest formula. This results in a compound interest of $5,000 x [(1+0.05) ^ 3 - 1], which equals $788.125. This means she would repay $788.125 + $5,000 to the financial institution, which equals a compound amount of $5,788.125.
Compound interest example for an investor
This example shows how to calculate the compound interest for a business that invested in a scheme:
Mohammed deposited $5,000 in a savings account. The bank applies a compound annual interest rate of 2.8%, which accrues every month. After one month, Mohammed's had $11.67 in compound interest. He arrived at this value by applying the compound interest formula 5,000 x [(1 + (0.028/12)) ^1- 1]. After two months, he had $23.36 in compound interest. This is the result of 5,000 x [(1 + (0.028/12))^2 - 1]. In three months, the interest he received was $35.08, using the formula 5,000 x [(1 + (0.028/12))^3 - 1].
By the end of the first year, he received $141.81 in compound interest using a compounding period of 12 because there are 12 months in a year. At the end of five years, Mohammed would have $750.43 in compound interest by using 12 x 5 months as the compounding period. If he decides to withdraw his money at this period, he would have $750.43 + $5,000, which equals a compound amount of $5750.43.
Tips for calculating simple and compound interests
Here are the best practices to help you make accurate simple interest and compound interest calculations:
As interest calculations typically involve decimals, fractions, and percentages, always aim to use a calculator. If you perform several simple or compound interest calculations, you can also use online software. These applications help you complete calculations quickly because they require you to include only your values. Check the online calculator you may want to use for accuracy by confirming the values in examples shown.
Write your values
Ensure you have your values on a computer screen or paper before you start your calculations. Doing this can help you reference the information you need for simple and compound interest formulas. It can also help you confirm that the interest rates align with the timeframe.
Review your calculations
Check your calculations for errors before you present your findings. If possible, have a mentor, colleague, or friend review it. For example, you can confirm that you multiplied the correct values when calculating simple interests. You also want to check whether you performed exponents on the correct values when finding the compound interest. Always review your answer if you have a negative or zero interest because interest calculations generally have positive values.
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