The Difference Between Simple Interest and Compound Interest
We will be going into the difference between simple interest and compound interest. The results can be astounding when comparing the two results of any kind of example when comparing the two. To understand your finances and how your money works this will be a very integral part of knowledge.
The first and most important difference between these two types of interest is that in compound interest you begin to earn interest on the interest that you earned in the prior period. In simple interest this is not the case. In simple interest, which is used primarily in loans and short term periods, the principal is the only amount the interest is calculated from. In other words, you are going to accumulate a lot more interest when the interest is calculated by using compound interest.
When dealing with compound interest the interest is calculated on a daily, monthly, quarterly, semi-annually, or annually. The formula that is used to calculate this interest on a bond for example would be Interest= Principal x Rate x Time (number of periods). By looking at this formula you can tell how the number of periods is going to be much different from how it looks in the simple interest formula.
When using simple interest the interest is calculated on a daily or monthly basis. The standard amount of days used in a calendar year is 360 rather than 365. The formula to calculate simple interest on a loan for example is also Interest= Principal x Rate x Time (a fraction such as 6/12).
As you can see by comparing the two formulas the difference between the “Time” portion of the formula is significantly different. By looking at this anyone can easily see why compound interest accumulates at such a higher rate than simple interest. Anyone who has any type of investments can easily see that they would much more prefer compound interest and people with loans would much more prefer simple interest.
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