What is the difference between simple and compound interest?
You still don’t know the differences between simple and compound interest rates?
When we go to a bank to apply for a loan or to invest our savings, we find two types of interest, simple interest and compound interest. In this article I will develop these concepts, what are their differences and I will share the formulas so you can calculate the return on an investment or the cost of a credit.
Before managing a loan or making an investment it is very important to know what simple interest and compound interest are about. Here you will find what you need to know to understand the two types of interest and to be able to calculate the profitability and cost of each one. So we will better capitalize on our savings or avoid being cheated on a loan.
Before knowing simple interest and compound interest it is vital to know what interest is.
Interest is the cost of using money and can be charged with two different types of interests, simple interest or compound interest. In this way, the lender gets a profit for providing the money for a certain period of time..
The simple interest rate is when the interest we get at the end of each period do not accumulate in the initial capital.The interest that we generate is not reinvested on the capital that we invested basically. Then the interest it is calculated throughout the operation on the same amount (the initial). In short, simple interest:
- Maintains the same initial capital during all periods.
- We get the same interest in all maturities.
- The interest rate is always calculated on initial capital.
If you want to know what is the formula of simple interest, I tell you that simple interest is calculated like this:
I = C * i * n
i= Interest rate
Let’s imagine that we need to calculate the simple interest that a capital of 10,000 euros invested during 4 years produces at a rate of 2% per year. We would do it as follows:
I = 10.000 * 0,02 * 4 = 800
The interest that we are going to receive at the end of each period is 800 euros.
The rate of compound interest is generated when the interest earned at the end of each period, accumulate in our initial capital, giving rise to new interest on each maturity.
Other than simple interest, we do not receive it at the end of each period, but we re-invest it in our initial capital, so the capital grows in every maturity, also increase interest because it is calculated on a larger capital period after period. In short, in compound interest:
- The initial capital grows at the end of each period as the interest generated is added.
- The interest rate is calculated on the capital that varies.
- Interests grow over time.
If you want to know what the formula of compound interest is, I’ll leave it below:
i= Interest rate
VF= Final value
Let’s continue with the same previous example, this is how we notice their differences. Let’s imagine that we need to calculate the compound interest produced by a capital of 10,000 euros invested during 4 years at a rate of 2% per year, we would do it as follows:
VF = 10.000 * ( 1 + 0,02 ) ^ 4 = 10.824,32
If you compare the two examples, you will see that 24.32 euros more have been generated through compound interest than with simple interest, in the same period of time
Differences between simple and compound interest
The differences between simple interest and compound interest are often summarised in one characteristic: whether or not we accumulate interest on the initial capital.
In the compound interest we accumulate interest on initial capital generating new interests, therefore we are earning more money or increasing debt over time. On the other hand, in simple interest, interest does not accumulate in the initial capital, therefore it will always be the same amount of interest at the end of each period throughout the operation.
Advantages and disadvantages of simple interest
Simple interest has some important advantages:
- We can choose to keep the interest produced or use the interest in other options where you can generate new profits (shares, cryptocurrencies, etc).
- If instead of being an investment, it is a debt, the interest generated is not accumulated again. Therefore, it does not increase the amount to be paid month by month.
And on the other hand the main disadvantage is that:
- does not capitalize the interest paid in previous periods and for this reason they lose purchasing power.
Advantages and disadvantages of compound interest
Compound interest has this main benefit:
- Its main advantage is that all interests are capitalised continuously, generating new interests.
And on the other hand the main disadvantage lies in that:
- You will not have your money at the end of each period but interest will automatically be reinvested, adding to the initial capital.
- Usually, the financial institution pays the first earnings after 12 months.
I hope you enjoyed this explanation about the concept of interests, both simple and compound. See you in the next article.