Simple and compound interest are the terms which every person in his or her life encounters and those who have not heard these terms belong to barter system of economics when there was no money and banks. However even though all of us have heard these terms still there is always a confusion regarding these terms as many people fail to differentiate between these two terms. In order to remove this confusion, given below are some of the differences between simple and compound interest –
Simple interest refers to that amount which is calculated on principal amount while compound interest refers to that amount which is calculated on both principal and interest.
Simple interest is calculated using the formula I = PRT where P is principal, R is rate of interest and T is time. Formula for Compound interest is A = P (1+R/N) nt, where P is Principal, R is rate of interest in decimals, N denotes number of years, n denotes number of times it is compounded and t represents number of years for which amount is deposited.
Suppose if you have put $1000 into the bank for 2 years on 10 % rate than at the end of 2 years you would receive $1200 if bank pays simple interest on deposits, however if bank follows compounding system than would receive $1210 because in this case you are receiving income on interest also and hence the difference of $10 between the two.
One will always have higher earnings if one invests his or her money into the bank which is paying on the basis of compounding or in simple words earnings from compounding will always be higher than simple interest. However it should be noted that at the end of 1st year earnings from both will be same as the effect of compounding comes into effect only after 1st year.
5. Principal amount fluctuation
In simple Interest, the principle amount on which calculation is made remains the same, whereas in case of compounding, the principal amount on which calculation is made does not remain same because amount at the end of the first year becomes the principal for the second year and so on.