Introduction
Interest, which is one of the most commonly used financial terms is nothing but the cost of borrowing money. When one borrows money from a financial institution, they pay an annual interest in lieu of the money that is borrowed. Interest is generally expressed in percentages and it can either be simple or compounded. One of the major differences between simple and compound interest is the way in which interest builds up.
Before diving into the details, let us first understand the meaning of simple and compound interests.
What is a Simple Interest?
Simple interest is the percentage that is charged on the principal sum of money that is lent or borrowed. Similar to this, when you deposit a particular amount in a bank, you can also earn interest. The concept of simple interest is widely used in many industries, including banking, mortgages, autos, and other financial institutions.
The formula used for calculating simple interest is as follows:
SI = (P * R * T) / 100
Where,
SI = Simple Interest
P = Principal
R = Rate of interest (expressed in percentage)
T = Time duration (in months or years)
If time, rate of interest and the principal amount is known, the simple interest can be calculated using this formula.
To calculate the total amount (A):
Total Amount (A) = Principal (P) + Interest (I)
Where,
Principal (P) – The amount that was first put in a bank or borrowed is known as the principle.
Rate of interest (R) – The interest that is charged on the principal amount.
Time (T) – This is the time frame during which money is deposited or borrowed. Typically, time is described in terms of months or years.
Amount (A) – The total interest and principal for a specific time period are added to determine the amount.
For Example,
If my friend deposited 100,000 rupees in a bank for 3 years and it accrued interest at a rate of 4% annually.
Then,
Principal (P) = 100,000
Time (T) = 3 years
Rate (R) = 4% p.a.
The values in the simple interest formula should be substituted;
SI = (P * R * T) / 100
= (100000 * 4 * 3) / 100
= 12000
She earned an interest of 12000 rupees
The total amount received by her would be
A = P + I
= 100,000 + 12,000
= 112,000
What is a Compound Interest?
The interest that is calculated on both principal and previous interest and is compounded on a regular basis is known as compound interest. The interest is computed on a new principal every time. This principle is the cumulation of the accrued interest and the original principal.
The formula for calculating the amount:
Compound interest can be calculated annually, semi-annually, quarterly, or even monthly. This is similar to how reinvested interest in an investment accelerates the growth of the principal over time. It is exactly what money does due to compound interest. Banks and other financial institutions only calculate the amount using compound interest.
The total amount at the conclusion of the time period, which includes the principle and compound interest, is represented by the formula above. Moreover, by deducting the principal from this sum, we can get the compound interest.
To compute compound interest:
In the above expression,
- P is the principal amount
- r is the rate of interest(decimal)
- n is frequency or no. of times the interest is compounded annually
- t is the overall tenure.
For example,
If an investment yields a monthly compounded return of 4%. Let’s calculate the value after 5 years, on rupees 7,000 initial investment.
Earnings of 4 percent compounded monthly are calculated using the formulas (r) = 0.04 and (n) = 12. The first investment or (P)=7000 and the time period or (t) = 5
Let us first calculate the value of A (the value after 5 years). Apply the formula now using the values that are known:
A = P (1 + r / m)mt
= 7000 ( 1 + 0.04 / 12) 12 * 5
~ 8547
Now, the compound interest can be calculated by subtracting the principal from the final amount
CI= A – P
CI= 8547 – 7000
CI= 1547
What is the power of compounding?
The power of compounding is the process through which interest accrued and is added back to the principal amount over time, increasing the value of an investment. Investors use the concept of compound interest to leverage the power of compounding. Compound interest raises the potential interest for the subsequent cycle by earning interest on your principal amount and adding it back to the principal.
The advantages of the ability of compounding are as follows:
- It assists in significantly increasing the principal amount over time.
- It enables investors to generate returns while also raising the return potential for the following cycle.
- When compared to simple interest, the power of compounding accelerates the rate of return on investments.
- Any financial instrument can use the power of compounding to boost its return potential.
- In-depth financial understanding is not necessary for successful implementation.
Difference Between Simple Interest and Compound Interest?
If put in the simplest way, simple interest is beneficial if you are borrowing money, whereas compound interest is helpful if you are investing. For borrowers like us, simple interest is preferred because you aren’t paying interest on interest. Simple interest makes paying off debt easier.
Compound interest, on the other hand, can help you build wealth over time as the earnings retained here produce income.
Another important point of distinction is that while the principal remains constant when computing simple interest, it varies for the calculation of compound interest.
Conclusion
Both simple and compound interests are widely used for interest calculations and are important to understand. While simple interest is common for taking short-term debts which last for less than a year, compound interest is mostly applied on loans having longer time periods.
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