SIMPLE VERSUS COMPOUND INTEREST
Difference between Simple and Compound Interest
Setting aside security and safety, banks and other financial institutions offer a particular
percentage on the amount of money, they borrow or invest. When a client invests his money, the
bank pays him an interest. Conversely, when a client borrows money from the bank he earns
an interest. In short, interest is charged as a cost of borrowing or it is received as an earning
interest method and the other is compound interest that is the more commonly used method by
financial institutions.
Computing for simple interest is basically simple. Earnings are computed based only on the
principal amount. The principal is the amount of money that is initially invested. Your earnings
grows slowly with a simple interest that you earn on your original balance. The formula to
compute simple interest is as follows:
I=P*R*T
Where: I= simple interest
P= principal or investment
T= time
annually. Your investment will yield $20 USD using the simple interest method. Since interest
is computed only on the original investment, you expect to earn the same amount of interest
next year.
Albert Einstein once said, “The most powerful force in the universe is compound interest.”
This saying holds true in the financial world. Computing for compound interest is a bit
complicated compared to that of simple interest. This is because the compound interest
becomes part of the principal. In short, when we use compound interest, we compute
SIMPLE VERSUS COMPOUND INTEREST
earnings not only on the principal but also on the interest previously earned. Compared to that of
the simple interest, compounding allows an investment to grow more.(Ragdale,2011.).
For example, a $200 account in a bank that earns 10% annually will yield $20 during the first
will arise in the second year when you compute the interest on the principal and also on the
interest earned in a year. Remember that compound interest is interest that is earned on both
the principal and on any interest from the past year, assuming that the earned interest is added
back to the original investment.
Let’s say an account has a $200USD invested for 3 years at a rate of 10% compound interest.
The formula to compute for the compound interest is as follows:
M= P (1+i)ⁿ
M= final amount including the principal
P= principal
i= rate of interest
Using the formula: M=200(1+.10)³=266.20
within a span of three years the investment added up to $266.
Which is the preferable way to invest? Remember, with simple interest method your
investment grows slowly because the interest is computed only on the principal while with
compounding, the earning process is faster because the interest is computed both on the principal
and the accumulated earnings. However, it is important to note that even if compound interest is
said to be a powerful force, its’ effect is negligible if applied in a small amount and over a short
period of time. The time value of money is seen on the interest earned over time. The key is to
invest a considerable amount of money over a longer period of time in order to accumulate better
earnings.
SIMPLE VERSUS COMPOUND INTEREST
References
Ragdale, D. (2011,). Simple and Compound Interest. Beat the Gmat.
Retrieved from http://www.beatthegmat.com/mba/2011/03/26/simple-and-compound-interest.
Russel, D. Compound Interest Formula. About Education.
Retrieved from http://www.math.about.com/od/formula/compound.htm.
