Simple Interest vs Compound Interest: Understanding the Key Differences

Whether you make an investment towards or take a loan from a financial institution, the interest is the cost incurred on the principal amount gradually. Now you must be wondering – why is simple interest vs compound interest even a topic in the first place. It’s because the interests accumulated on an investment or a loan are vastly different according to these two methods. Simple interest is calculated on the principal amount, but compound interest is calculated on the principal amount plus the interest accumulated over time.

Compounding is all about a framework wherein interest earns interest. It means when earnings from compound interest are reinvested, both the principal amount and the reinvested earnings grow together constantly. Suppose you want to understand the power of compound interest for your investment. In that case, you can use the features of the compound interest app from the CWS Financial Planning Calculator to your benefit. Let’s discuss the key differences between simple and compound interest in detail below.

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Key differences between simple interest and compound interest

1. The formula for interest calculation

Simple interest and compound interest have different formulas for interest calculation. You might find calculating compound interest a bit tricky because it involves the variable of compounding periods, which can change over time.

Simple Interest = P*r*n, wherein,

  • P = Principal Amount
  • r = Rate of Interest in %
  • n = Number of Time Periods Annually

Compound Interest = P{(1 + r)n-1}, wherein,

  • P = Principal Amount
  • r = Rate of Interest in %
  • n = Number of Compounding Periods Annually

2. Accumulation of interest

You will always get higher returns on your investment with compound interest than simple interest. However, if you apply for credit, the interest calculated per the simple interest method will stay lower than the compound interest method. It’s because all the variables like principal amount, rate of interest, and the number of time periods remain static right throughout for simple interest. But that isn’t the case with the variable of compounding periods used to calculate compound interest.

3. Scope of growth

The scope of growth in principal amount and simple interest stays constant in its entire timeframe. But the principal amount and compound interest growth happen rapidly due to the compounding effect as time goes by. If you like to see the growth opportunity for your investment based on compound interest, check out how the compound interest app from the CWS Financial Planning Calculator can work in different situations for you.

financial expert discussingsimple interest vs compound interest4. Usage options

Simple interest works fine if you take loan money from a financial institution. Meanwhile, if you invest money anywhere, compound interest allows you to earn that interest on interest gradually. Certificate of deposits (CDs), dividend reinvestment, buy-and-hold investment, and treasury securities are some of the great options to make a compound interest investment.

The practical implication of simple interest vs compound interest

Let’s say you are looking to invest $1,000 in a financial institution for five years at an interest rate of 5% annually. If you put the money in the compound interest option, you will earn $276; however, you will only earn $250 with the simple interest option. That’s an extra return of $26 on the same investment but with a different interest scheme.

Simple interest vs compound interest calculations made easier with the CWS Financial Planning Calculator

Whether you are new to the world of finance or making investments for long, simple interest vs compound interest calculations can become a hassle at times. That’s when the CWS Financial Planning Calculator can help you calculate compound interest with ease and create a financial plan that works. To use this facility, download the all-in-one compound interest app from App Store or Google Play today.

Harvey Neiman

Harvey Neiman serves as President and Chief Investment Officer of Neiman Funds Management LLC based in upstate New York. Read his new book, Customize Wall Street, and see how anyone can invest in Wall Street.

Harvey earned his bachelor’s degree in Political Science at U.C. Santa Barbara, his JD degree at University of San Diego School of Law, and later earned an LLM degree in Taxation, also at USD School of Law.