Home » Education » Learn about simple interest and compound interest

If an individual has a saving bank account and he deposits a huge sum of money then the bank will pay some extra money for having a saving account with them. In the same way, if an individual borrows some money from a bank then the bank will need extra money from an individual who has borrowed. This extra money depends entirely on the interest rate of the bank. They usually make money by expecting more from the loans than the saving accounts. Therefore, it is necessary for an individual to understand the different forms of interest rates including simple interest and compound interest. This article will enlighten people about the types of interest rates.

Interest Rate Definition

Interest rate refers to a rate that is paid or charged for the money use. It is usually known as an annual percentage. It can be calculated by dividing the interest amount to the principal amount. The interest rate is influenced by the fiscal policy, money supply, inflation rate, and borrowed amount. For instance, a bank charges $80 per year on $1000 loan then the interest rate according to the above formula would be 8%.

simple and compound interest definition

There are two types of interests which are discussed below:

  • Simple Interest

Simple interest can be calculated by multiplying the period’s number in a loan and the principal amount. In general terms, the simple interest received or paid is a fixed percentage of the borrowed or lent principal amount. For instance, an individual gets a simple interest loan of $1800 to pay his house rent annually and the interest rate per year on that loan is 6%. He repaid that loan after 3 years and the amount was $3240. So, the total repaid amount on that loan would be $21240.

  • Compound Interest

The compound interest is the amount that an individual earn from his first investment apart from the interest he earns. It can be calculated by multiplying the annual interest rate plus one raised to the compound period’s number minus one and the principal amount. The compound interest can be used frequently or infrequently but the more often interest compounds would help an individual to earn more on his investment. For instance, if an individual invests $2000 at 8.5% of interest rate then the end amount would be $3032.43 after 5 years. An individual will earn $1032.43 in the compound interest.

Difference between simple and compound interest

Both the types of interests differ from one another in many terms. The difference between simple interest and compound interest is discussed below:

  • Compound interest is difficult to understand or calculate as compared to the simple interest.
  • Compound interest allows the fund to grow at a faster rate than the simple interest.
  • In the simple interest, the interest is taken only from the loaned amount while in the compound interest, the interest is taken from both the lent amount and the accumulated one.
  • The amount of interest is lower in the simple interest than the compound one.
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