Simple interest simply refers to the extra money charged on a loan or earnings from an investment. This type of interest can be determined by multiplying the principal by rate by time which can be in years or months depending on the designated timeframe (Lewis, 1981).
Simple interest (I) formulae
,where
P-refers to the investment amount
R- is the interest rate per year
T-refers to the time taken of period for the loan or investment
Compound interest (A) formulae
, where
P-refers to the investment amount
r- is the annual nominal interest
I- represents the interest rate
n- is the number of compounding periods per unit
nt- Number of times the interest is compounded per year
The simple interest most often does not include the effects of fees charged over time and in the total cost this type of interest is not reflected.
Advantages of simple interest
It is convenient when one is opting to go for short term loans because they are more affordable and they can be paid with ease. It’s paid only on the money you save or invest. The saved amount is what dictates the amount of interest to be attained.
This type of interest encourages borrowing because it can be paid comfortably within a short period of time because money received at the opportune time, allows one to use it for investments or for everyday consumption which is conceptually known as the value of your money.
Disadvantages of simple interest
One may not acquire the required interest if one makes a quick return of the money before the end of the grace period provided.
Only a small amount of profit is attained. Because investment is within a short period of time, it directly reflects to the small amounts of money obtained as interest.
It discourages bank savings because many people opt to take family borrowings to avoid the lengthy procedures of borrowing from banks.
Advantages of compound interest
It’s cumulative hence advantageous to a person who is in business because he is assured of a long term reward and profits.
The much one invests makes him or her to accrue more profit within the specific investment. The more the money invested, the more the interest obtained
With compound interest one still continues to earn on the initial principle. The value of the money invested increases from the amount invested and this is realized at the end of the investment period (Lewis,1981).
Disadvantages of compound interest
One has to have his money in the bank so that interest can build up and accumulate. One cannot acquire interest unless he or she has made an investment decision.
In case one borrows from a family member and the borrower defaults the loan maybe because of mistrust and conflict issues one suffers great financial loss.
Similarities between compound and simple interest
Both simple interest and compound interest increase and grow the amount of money invested. Some value is added to the initial amount which is invested and the amount does not remain the same in the investment period descried.
Both simple and compound interest there is direct reflection of the cost of borrowing money from the bank.
Differences between simple interest and compound interest
Simple interest is calculated only on the principle one has invested or borrowed while compound interest is computed on both the principle and the already accrued interest.
Simple interest one does not require one to necessarily need to bank his money because he can obtain money from family borrowing while in compound interest it requires one to invest money in the bank so as to get the accumulation hence be compounded within the investment period.
Simple interest is usually sympathetic in short term accounts while compound interest is used on long term accounts. This is because it simple interest acts like money which has been borrowed and invested of under crisis unlike compound interest which has considerable period of time described in the venture agreements and conditions.
Simple interest is often steady while compound interest has an exponential growth. For example if one has invested a large amount of money, he continues to get more interest with the length of time he has let his or her money in the bank or investment agency.
References
Lewis, C G (1981). Compound Interest In The Seventeenth Century. Journal of Actuaries 108(3)
