When it comes to saving money, there are two main types of interest that you can earn: simple and compound. Simple interest is calculated only on the principal balance of your savings, while compound interest is calculated on both the principal and any interest that has already accrued. So, which is better?
There are pros and cons to both simple and compound interest. With simple interest, you know exactly how much interest you’ll earn on your savings because it’s calculated at a fixed rate. This can make it easier to budget and plan for your future. However, compound interest has the potential to earn you more money over time because the interest is added to your principal balance, meaning you’ll earn interest on your interest.
The best way to decide which type of interest is right for you is to consider your savings goals. If you’re looking to save for a specific goal, like a down payment on a house or a new car, simple interest may be the way to go.
What is compound interest?
Compound interest is calculated as a percentage of the principal amount plus all prior interest. In other words, the amount of interest added to the principal is determined for each interest-accruing period based on the principal plus the interest added in the prior period. Compound interest can work against you as a borrower because it accrues more quickly than you can pay down the principal.
You can use the following formula to determine the annual compound interest you would accrue:
I = p x (1 + r)t – p
In that equation, t is the number of accrual or compounding periods in a year, p is the principal amount, and r is the interest rate. You must modify the formula if there are more than one compounding period per year:
I equals px (1 r/t)tx y – p.
In this formula, y stands for the number of years.
Compound interest examples
These examples can be used to illustrate how simple interest functions:
You open a savings account and deposit $5,000 into it. The bank applies a compound interest rate of 2. 8 percent. Interest accrues every month.
After one month, your investment has added $11. 67 in interest. You get there by using the equation: 5,000 x (1 (0 028/12))1- 5,000. After two months, you have $23. 36 in interest. This is the result of 5,000 x (1 + (0. 028/12))2 – 5,000. After three months, the total interest is $35. 08, or 5,000 x (1 + (0. 028/12))3 – 5,000. You will have added $141 by the end of the first year. 81 in compound interest.
Five years from now, you will have added $700. 43 in compound interest.
The figures would be different if the bank added compound interest to your deposit over time in equal installments.
You would have accrued $140 in compound interest on your deposit after the first year. After two years, this would become $283. 92 in interest. You would have $431 in compound interest at the end of the third year. 86.
You would have $740 at the end of the fifth year. 31 added to your deposit in compound interest.
What is simple interest?
I = p x r
The amount to be added to the principal each accrual period, such as each year, is known as the interest (I), which is calculated by multiplying the principal (p) by the interest rate (r). You would multiply that interest by the time period if you wanted to know how much interest would be accrued over the course of a loan:
I = p x r x t
In that formula, t is the duration of the loan.
Simple interest examples
These examples can be used to illustrate how simple interest functions:
You borrow $5,000 to be repaid over five years. The bank charges you a simple interest rate of 2. 8%. It’s a fixed percentage that won’t change. You can figure out how much simple interest you owe overall by applying the formula I = p x r x t: 5,000 x 0. 28 x 5, which comes to $700. Over the course of five years, you’ll pay a total of $700 in simple interest.
You deposit $1,000 into a savings account that accrues 2. 8% simple interest every month. The monthly interest amount is 1,000 x 0. 028, which is $28. The total amount of simple interest accrued after 15 years will be $5,040. That is, 1,000 x 0. 028 x 180 (the number of months in 15 years).
Simple vs. compound interest differences
There are some significant differences between simple and compound interest:
Simple vs. Compound Interest
FAQ
What is better simple interest or compound interest?
Compound interest is preferable when it comes to investing because it enables money to grow more quickly than it would in an account with a simple interest rate. You must account for compound interest when determining the annual percentage yield. That represents the annual return on investment or the annual cost of borrowing money.
What is the difference between simple interest and compound interest with examples?
Calculating simple interest on a loan’s principal, or initial sum, Compound interest is often referred to as “interest on interest” because it is calculated using both the principal amount and the accrued interest from previous periods. ”.
What is the difference between simple and compound interest formula?
Calculating simple interest on a loan’s principal, or initial sum, Compound interest is often referred to as “interest on interest” because it is calculated using both the principal amount and the accrued interest from previous periods. ”.
