Difference Between Compound Interest and Simple Interest
Before one can grasp the difference between compound interest and simple interest, one must learn the process used by each to calculate interest. Also, the terms used will make a difference if you are the loaner or the borrower.
Compound Interest Loan
Compounding is defined as the increasing value over a set time period from one single payment. This interest earned will be added to the original borrowed amount, reinvested to the original amount to earn additional interest from each additional payment. Simple interest that is earned on the original borrowed amount will not be reinvested. The term for this earned accumulated interest on the original amount is called an annuity.
Future value (FV) is another term one should get familiar with. A future value is the total of money that will be paid in the future on the borrowed funds. A lender will expect “interest on interest” back. This means the interest earned from earlier payments will be assumed to be reinvested to earn interest in future payments on the loan. The formula for calculating a three year loan using compounding interest is shown below:
*FV at the end of year 1 = the amount borrowed + interest earned = amount borrowed + year 1 interest
*FV at the end of year 2 = the amount borrowed + interest earned = amount borrowed + year 1 and year 2 interest
*FV at the end of year 3 = the amount borrowed + interest earned = amount borrowed + year 1, year 2 and year 3 interest
Simple Interest Loan
Simple interest infers that the interest earned on each loan payment is withdrawn and not reinvested. The formula for calculating this type of interest rate is:
*Simple interest = principal x rate x time
As you can see most lenders prefer making compound interest loans. This is because the interest amount on this money loan grows more interest back to the lender. While interest earned on a simple interest does not increase and is a set amount of interest to be paid on the loan.
A borrower would probably prefer the simple interest loan. Mainly because he/she will know exactly how much is borrowed and how much interest will be due to pay off the loan. Less interest will be owed with this type of loan compared with the compound loan.
Reference:
B.J.Winger and R.R.Frasca, Finding Future Values, Retrieved from Personal Finance (7th ed.) copywrite 2006 by Pearson Education, Inc., Upper Saddle River, NJ,07458 pages 22-23 on June 12, 2011