Simple vs compound interest

Simple vs compound interest is not hard to understand. Basically, simple interest is interest paid on the original principal only while compound interest is interest paid not only on the principal, but also on the interest previously earned.

Simple vs compound interest: an example showing the difference between the two.

For example, 4000 dollars is deposited into a bank account and the annual interest rate is 8%.

How much is the interest after 4 years?

Use the following simple interest formula:

I = p × r × t

where p is the principal or money deposited

r is the rate of interest

t is time

We get:

I = p × r × t

I = 4000 × 8% × 4

I = 4000 × 0.08 × 4

I = 1280 dollars

However, compound interest is the interest earned not only on the original principal, but also on all interests earned previously. You are basically paying interest on interest!

In other words, at the end of each year, the interest earned is added to the original amount and the money is reinvested.

If we use compound interest for the situation above, the interest will be computed as follow:

Interest at the end of the first year:

I = 4000 × 0.08 × 1

I = 320 dollars

Your new principal per say is now 4000 + 320 = 4320

Interest at the end of the second year:

I = 4320× 0.08 × 1

I = 345.6 dollars

Your new principal is now 4320 + 345.6 = 4665.6

Interest at the end of the third year:

I = 4665.6× 0.08 × 1

I = 373.248 dollars

Your new principal is now 4665.6 + 373.248 = 5038.848

Interest at the end of the fourth year:

I = 5038.848 × 0.08 × 1

I = 403.10784 dollars

Your new principal is now 5038.848 + 403.10784 = 5441.95584

Total interest earned = 5441.95584 − 4000 = 1441.95584

The difference in money between compound interest and simple interest is 1441.96 - 1280 = 161.96

As you can see, compound interest yield better result, so you make more money.

Therefore, before investing your money, you should double check with your local bank if compound interest will be used.

Having said that if you have a credit card and you owe money on it, you will pay less interest if the credit card company uses simple interest. However, they will never do something so foolish!

I hope simple vs compound interest is well understood now!

Here is a figure summarizing the difference between simple interest and compound interest

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