The difference between simple interest and compound interest
/What is Simple Interest?
Simple interest is an interest charge that a lender charges to a borrower on a loan. It is calculated based solely on a percentage of the loaned amount. There is no compounding of the interest. This results in an easily calculated interest charge over the life of a loan. It is calculated as the remaining principal on a loan multiplied by the annual interest rate.
What is Compound Interest?
Compound interest is an interest charge that a lender charges to a borrower on a loan, and which results in a higher interest charge than what would be calculated using simple interest. It is calculated based on a percentage of the loaned amount and accumulated interest. In effect, charging interest on the outstanding amount of interest increased the amount owed. The higher the frequency of compounding, the higher the return will be for the lender.
Comparing Simple Interest and Compound Interest
These variations in how the interest calculation is derived result in four differences between simple and compound interest, which are noted below.
Differences in the Amount Charged
The amount of interest charged is lower when simple interest is used, since this calculation does not include a charge for any interest outstanding. The amount charged when compounding is used can vary, depending on how frequently the compounding calculation occurs. For example, a loan that compounds daily will result in larger payments than a loan that only compounds semi-annually.
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Differences in the Payoff Amount
Since there is no charge for any interest outstanding, it is less expensive for the borrower to pay off a simple interest loan.
Differences in the Principal Balance
The principal balance of a loan remains the same when simple interest is used, unless the loan balance is specifically paid down. The principal balance increases when compounding is used, since more interest is added to the loan, which may not be paid down by loan payments.
Differences in Application
Simple interest is more commonly applied to short-term loans that extend for less than a year, while compound interest is nearly always applied to loans having longer periods.