Difference Between Simple Interest and Compound Interest
Difference between simple interest and compound interest: In a financial situation where you need to borrow money from acquaintances or take a loan from a bank or make investments, you would be required to pay an additional amount of money. This extra amount is like a “Thank you” charges the lender for lending you that amount. The learned term for this extra sum is called interest.
When it comes to investments, however, the extra money paid to the lender who invested is also called interest.
Interest is defined as the percentage of the original loan amount that must be added to the loan amount that must be repaid over a given period. It is the cost of borrowing money from a person or business when the borrower pays a fee to the lender for a loan as a privilege to use their money.
An example is a scenario where you will be credited if the customer deposits money in the bank and leaves it for a certain period of time. The borrower is the issuing bank, while the lender is the one who holds the deposited money. The bank invests the funds to create a profit, which is then used to pay interest to their customers.
Therefore, we can say that what is needed to borrow money is more money. The most common forms of interest are simple interest and compound interest which depends on tax considerations, credit risk, term and convertibility of the loan in question. It is important to remember that interest and profit are not the same things, even though they are related.
The distinction is that interest is paid by the lender, who may or may not be the business owner, while profit is paid by the asset or business owner. As we distinguish between simple interest and compound interest, this can be useful in deciding what type of interest to pursue while investing or taking out a loan.
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What is simple interest?
Simple interest is just the principal amount of a loan or deposit made in a person’s bank account. It is a predetermined percentage of the principal amount borrowed. Simple interest does not take into account prior interest. It is based solely on the original donation amount. Borrowers earn on simple interest, while investors suffer as they have to pay interest only on accepted loans because there is no compounding power. Simple interest is easily calculated by multiplying the amount of interest by the tenure and principal proportion.
How to Calculate Simple Interest
Simple interest is calculated mathematically by multiplying the principal by the interest rate for a certain time and duration which can be in days, weeks, months and even years. Therefore, the interest rate must be converted accurately before multiplying it by the principal amount and the term.
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Simple interest = principal x interest rate x time
I = (P * R * T) / 100
I = simple interest
P = principal amount which is the original sum of money
R = Interest rate for a certain time in percentage.
T = time interval
For example, you take out a 40,000# loan from a private company that offers three-year repayment terms. A base interest rate of 2% is charged by the company. It is a fixed proportion that will not change.
To determine the amount of simple interest you owe, use the following formula:
i = (2,400 x 2 x 3) / 100 i = (P x R x T) / 100 i = (40,000 x 2 x 3) / 100
Therefore, you must pay a total of $2,400 in simple interest over three years.
Here are some examples of simple interest:
Car credits: Because a car is considered a liability, their loans regularly depreciate, suggesting that the interest payable decreases as the loan balance decreases each month, implying that a higher percentage of the monthly payment is applied to the principle.
Early payment discounts: Suppliers frequently give a discount to encourage early payment of invoices in the business sector. This is a very attractive arrangement for the payer. For example, an invoice for $50,000 might offer a 0.5% discount for payment within a month. This equates to $250 for an advance payment. Certificates of deposit (a bank investment that pays out a certain amount of money on a predetermined date) and so on.
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What is Compound Interest
Compound interest is a type of interest that accumulates and compounds over time. It is a percentage of the principal amount, plus the interest already accrued. It is also possible to call it interest on interest. The whole premise is based on compounding the interest earned on the initial sum to generate substantial returns. The higher the compounding frequency, the higher the amount of accrued interest. As a result, investors benefit more than borrowers from compound interest.
Compound interest is the most common type of interest.
Fixed deposits, mutual funds, student loans, and investments all use this term. Compound interest is also used by banks when granting loans.
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How to Calculate Compound Interest
In order for one to calculate compound interest, there are a few issues to consider; How much money do you have to start? What was the total amount of money you borrowed? How long do you expect to hold a bank account or repay a loan? Do you plan to make frequent deposits into your account? How often will you repay your loan?
This is because compounding depends on how much you own or borrow, and the longer you keep money in an account or keep a loan open, the longer it takes to compound. The rate at which interest is compounded, as well as how you accumulate or repay your principal, affect how quickly you accumulate or repay your debt.
Compound interest is calculated using the principal and interest earned over a certain period.
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Compound Interest = Amount — Principal
Amount = P(1+r/n)^(nxt)
P = Principal amount
r = Interest rate converted to decimal
n = number of capitalization periods
t = Time interval in years
COMPOUND INTEREST = P[(1+r/n)^(n x t)] —P
For compound interest once per period, Amount A is:
A = P(1+ R/100)^t
A = Amount compounded annually
R = Interest rate in percentage
t = Number of times the interest is compounded
For example, if you have $2,000 in your savings account and earn 5% interest each year. Your balance would be #2100 after the first year, with an interest rate of #100. The balance of #2100, which became the new primary at the start of the second year, would earn you 5% after the second year. After the second year, the interest becomes #105 and the total amount is $2205. As a result, two years later, compound interest is #2205 — #2000 = #205.
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Difference Between Simple Interest and Compound Interest
Simple interest and compound interest can be distinguished as follows:
1. Since simple interest is calculated as a percentage of the principal, the amount is always the same. Since compound interest is a proportion of the principal plus interest earned or accrued to date, it varies from one accumulation period to the next.
2. With simple interest, the principle does not change. Compound interest is calculated by adding compound interest to the principal, thus increasing the principal.
3. Simple interest is easier to calculate. Calculating compound interest has a lot of variables to consider, and it’s a bit complicated.
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4. Compared to compound interest, simple interest gives lower returns.
5. When borrowing money for items like car loans, simple interest works to your advantage because the cost of the loan is the same for each payment. Compound interest is better than simple interest when investing or saving because your money will grow faster.
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Because compound interest rather than simple interest can cause the amount of interest payable on a loan to vary significantly, learning the basics of simple and compound interest can help you make smarter financial decisions, possibly enabling you to save thousands of naira and increase your net worth. over time through investments.
Edeh Samuel Chukwuemeka ACMC, is a law student and certified mediator/conciliator in Nigeria. He is also a developer with knowledge in HTML, CSS, JS, PHP and React Native. Samuel is determined to change the legal profession by creating web and mobile applications that will make legal research much easier.