What is The Difference Between Simple And Compound Interest?

Certainly! Let’s explore the key differences between simple interest and compound interest:

1. Simple Interest:
• Definition: Simple interest is calculated based only on the original principal amount (the initial sum of money) without considering any previously earned interest.
• Formula: The formula for simple interest is:

  $$\text{Simple Interest}=P\times r\times n$$

  where:
  • (P) represents the principal amount.
  • (r) is the annual interest rate (expressed as a decimal).
  • (n) is the term of the loan or investment in years.
• Example: Suppose a student borrows $18,000 for college tuition at an annual interest rate of 6%. Over 3 years, the student pays $1,080 in interest annually, resulting in a total repayment of $3,240¹.

Compound Interest:

• Definition: Compound interest takes into account not only the principal amount but also the interest already earned up to that point. In other words, it grows based on both the initial principal and the accumulated interest.
• Impact: Compound interest allows your savings or investments to grow faster over time. However, when borrowing, it can also lead to higher costs.
• Frequency: Compound interest can be calculated daily, monthly, or quarterly, depending on the terms of the investment or loan.
• Formula: The compound interest formula is more complex and involves exponential growth. It considers the compounding frequency (e.g., annually, semi-annually, etc.).
• Example: Imagine investing $10,000 at an annual interest rate of 8% compounded annually. After 5 years, the total amount would be higher than if it were calculated using simple interest alone.

In summary, simple interest is straightforward and based solely on the principal, while compound interest accounts for both the principal and previously earned interest. When comparing savings, loans, or investments, understanding these concepts helps you make informed financial decisions.