Simple Interest vs Compound Interest? Definition, Formula, Pros, and Cons Explained

Understanding the difference between Simple and Compound interest is essential when making a financial decision. There are two ways to calculate interest when taking a loan or investing. Simple interest accumulates on the principal balance, whereas compound interest accumulates on the principal balance and the accumulated interest. Today’s blog will explain simple and compound interest definitions, formulas, pros, and cons.

Simple interest

Simple interest (SI) is a fundamental concept in the finance world. It is calculated on the principal amount and does not consider the interest previously accumulated. 

It is an easy and direct method of calculating interest and is generally used for short-term loans or investments.  

Formula

Simple interest calculates the amount that includes only the principal. The calculation involves the principal amount, interest rate, and duration of the loan or investment. The formula is:

Simple interest (SI) = (P x R x T) / 100,

Where, 

P= Principal amount

R= Rate of interest

T= Time

Example

Assume that Mr. Khurana invested INR 2,00,000 in a fixed deposit for four years at a 7% simple interest rate p.a. Using the same formula, we can calculate the interest Mr. Khurana will earn from the investment. 

By using the formula of Simple interest, 

Simple interest= (2,00,000*0.07*4)/100

Then, SI = Rs 56,000.

At the end of 4 years, Mr Khurana will earn a total of Rs. 56,000 in simple interest. 

Pros

• Simple interest is easy to understand and implement since it does not provide interest on accumulated interest. Thus keeping the periodical interest constant. 
• SI allows for transparency to the borrower as the interest payments are easy to calculate and can be understood by all.
• SI is very useful in short term investments as compound interest would anyway not be material on short term investments. 

Cons

• Simple interest leads to slower wealth accumulation, especially for long-term investments.
• Simple interest may not be the most efficient option for people seeking high-return investments in the long term.
• Simple interest doesn’t allow for the reinvestment of earned interest.

Compound interest

Compound interest involves calculating interests on both the principal amount and accumulated interest. It works on a snowball effect, causing your money to grow faster over time than Simple interest.

The bank or any financial institution allows for compounding daily, monthly, quarterly, half-yearly, or yearly. 

Formula

A=P(1+r/n)^(n*t)

CI = A – P

Where,

“A” stands for Total Amount,

“P” stands for Principal Amount,

“r” stands for rate of interest,

“n” stands for the times of compounding in 1 period,

“T” stands for the number of periods 

Example 

Mrs. Chavi invested Rs 10,000 at the rate of 10% p.a. for five years.

Therefore, A = 10,000*(1+(.1/1))^(1*5)) =  16,105.1 

& CI = A – P = 16,105.1 – 10,000 = Rs 6,105

Pros

• It allows money to grow exponentially over time, as interest is earned on both the initial principal and the accumulated interest.
• Compound interest can maximize your returns by allowing your money to grow multifold over time.
• It can lead to substantial wealth accumulation, making it an ideal long-term investment strategy.

Cons

• If borrowers are unable to make timely payments or only pay the minimum amount due, compound interest can lead to a debt spiral where the debt grows rapidly, making it increasingly challenging to repay.
• Over time, compound interest can increase the total interest paid on a loan. As interest accumulates on both the principal amount and previously accrued interest, borrowers pay more in compound interest than simple interest.
• Compound interest calculations can be complex and hard to understand compared to simple interest. 

Read Also: XIRR Vs CAGR: Investment Return Metrics

Conclusion

The concepts of simple and compound interest are essential for anyone dealing with investments, loans, and savings. Simple interest provides predictable interest amounts, making it suitable for those who prefer an easy technique, whereas compound interest comes with complexity but can multiply your money quickly. CI is best for long-term investors and has the potential for exponential growth over time. Simple interest is calculated only on the principal amount and does not include interest on interest. In contrast, compound interest includes interest on the total interest as well as on the principal amount. 

Frequently Asked Questions (FAQs)