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Interest is defined as the cost of borrowing money, such as interest charged on the balance of a loan. But not only that, because when you talk about interest, you may also be referring to the rates that a bank pays the investor for the money that he has deposited in his financial institution. Did you know that interest can be calculated in two ways and that there is a difference between simple interest and compound interest? Read on to find out more about both types of interest.
Simple or compound interest?
When a person borrows money from a lender or from any bank or financial institution, the lender charges an additional amount for the use of the money, called interest. The interest rate is mutually agreed upon by both parties, and can be charged in two ways: Simple Interest or Compound Interest.
The first is the interest rate in which only the amount borrowed is charged, but in the case of compound interest, what is charged is calculated on the amount borrowed plus the accumulated interest on the principal.
That is, each time the interest is due for payment, it is added to the principal, on which the interest for the following period is calculated, this is known as compound interest.
Simple interest is calculated on the principal, or original, amount of a loan.
Compound interest is calculated on the amount of the principal and also on the accrued interest from previous periods and, therefore, can be considered as “interest on interest”.
There can be a big difference in the amount of interest payable on a loan if the interest is compounded rather than simple. On the plus side, the magic of compounding can be an asset to your investments and can be a powerful factor in wealth creation.
While simple interest and compound interest are basic financial concepts, becoming fully familiar with them can help you make better decisions when applying for a loan or deciding to invest in financial products like bank deposits.
If, for example, you are thinking of requesting a loan, it is advisable to first take into account the cost that requesting it may have for you. If you are going to request a loan, it is normal that you opt for those entities that impose lower interest rates. However, from an investor’s point of view, a high rate will be more beneficial.
Both simple interest and compound interest are popular options in the market, but do you know what their differences are? We detail them so that you can get to know these financial concepts much better.
What is simple interest?
Simple interest can be defined as the interest charged on the total amount of principal taken out for a particular period of time. Interest is only charged based on the use of funds. The simple interest calculation is quite simple and is the fastest way to calculate interest. An example of simple interest is car loans where interest must be paid on the amount borrowed.
The formula to calculate simple interest is: P * R * N
(P = Principal, R = Rate, N = Number of years)
The growth rate of simple interest is less than that of compound interest.
To give you a better idea of what simple interest is. If a borrower borrows $1,000 from a lender at 10% per year for three years, then the total amount of interest charged would be $300 and the total amount payable would be $1,300. Interest of 300 euros is charged for using the full amount that has been requested. The sum of interest and principal is known as the total amount. One point to keep in mind is that the greater the amount borrowed and the greater the number of periods, the greater the interest that must be paid.
In the case of credits, simple interest only applies when the debtor pays said interest within the agreed period. Otherwise, compound interest begins to accrue.
What is the composed interest?
Compound interest is calculated on the revised principal, which is calculated based on interest charged on interest earned . The principal amount, therefore, increases exponentially. Interest will be paid on the principal and on accrued interest.
The formula for calculating compound interest is: P {(1 + R) ^ n – 1}
(P = Principal, R = Rate, N = Number of years).
The return on compound interest is much higher than that on simple interest. In the case of investments or savings plans, the profits generated are added to the capital, and if a new period begins, the interest will be calculated based on this new capital . What does this mean? Well, the interest will be based on the previous capital plus the interest generated. Something different happens in the case of loans or credits, where the interest generated becomes part of the accumulated debt.
In this case, suppose that Alberto deposits 1000 euros in the bank and earns a return of 5% per year for a period of three years. How much interest will he receive at the end of the third year? Below we indicate how much you would get if it were simple interest and how much it would be if we were talking about compound interest.
The bases for calculations
| Main (P) | 1000 euro |
| Rate (R) | 5% |
| Time / period (T) | 3 years |
By using the simple interest formula
| Simple Interest Calculation | (P x R x T) / 100 |
| Simple Interest Calculation | 1000 x 5 x 3/100 |
| Simple Interest Calculation | €150 |
By using the compound interest formula
| Compound Interest Calculation | P[(1 + R)n – 1] |
| Compound Interest Calculation | 1000 x {(1 + 5/100)^3 – 1} |
| Compound Interest Calculation | €157,625 |
Basically, interest can be termed as a fee for using another person’s or entity’s money. Reasons for paying interest include risk, inflation, time value of money (compounding effect), and opportunity cost.
As we have explained in the formula above, simple interest is easy to calculate and compound interest is difficult and complex to calculate. If we calculate both simple and compound interest for a particular time, rate, and principal, then it is observed that compound interest is always greater than simple interest due to the compounding effect also known as the time value of money.
Understanding the difference between these two methods will allow you to choose the right loan or savings product, as well as find the best alternative to store your earnings.
The keys to both types of interest
Simple interest is calculated based on only a percentage of the amount borrowed, while compound interest is calculated based on a percentage of the amount borrowed and interest. The higher the frequency of compounding, the higher the return to the lender.
These variations in how the calculation is derived result in the following differences:
- Amount Charged: The amount of interest charged is less when using simple interest, since this calculation does not include a charge for any outstanding interest. The amount charged when capitalization is used can vary, depending on how often the capitalization calculation occurs. For example, a loan that is charged daily will result in higher payments than a loan that is only charged semi-annually.
- Payment: Because there is no outstanding interest charge, it is less expensive for the borrower to repay a simple interest loan.
- Balances: The principal balance of a loan remains the same when using simple interest, unless the loan balance is specifically paid off. The principal balance increases when capitalization is used, since more interest is added to the loan, which cannot be paid back through loan payments.
Whenever you have several investment alternatives, our advice is to analyze each proposal in detail to find out its characteristics.