Compound vs simple interest: Concepts, differences and calculations

When you invest your money or put it in a savings account, the additional income earned is known as interest. There are two main ways in which interest can be calculated - simple interest and compound interest. On the surface, both methods seem similar since they can help you earn more than your original capital. However, compound interest has the potential for your money to grow significantly faster compared to simple interest. Read on to learn more.

• Table of contents

1. What is simple interest
2. Concept of simple interest
3. What is compound interest
4. Concept of compound interest
5. What is the difference between simple and compound interest?
6. Potential for growth - Simple interest vs compound interest
7. Examples using calculator - SI vs compounding calculator
8. Which Is Better, Simple or Compound Interest?
9. How Interest Affects Your Money Over Time
10. Common Myths About Simple and Compound Interest
11. Additional points to know

What is simple interest

Simple interest provides a fixed return or cost over a specific period, based only on the initial principal. It results in a linear increase in the total amount. It's often used for short-term loans or certain types of investments where interest is not compounded.

Concept of simple interest

With simple interest, the interest is calculated only on the original principal amount invested. For example, if you deposit Rs. 1 lakh in a bank FD with 5% annual simple interest, you will earn Rs. 5,000 as interest every year.

The simple interest formula is as stated below.

• Simple interest = principal x interest rate x time

Example:

• Simple interest = 1,00,000 x 5% x 1 year = Rs. 5,000

The key aspects are as listed below.

• Interest accrues only on the original invested principal.
• The interest rate remains fixed.
• Interest earned is not reinvested to generate further gains.

What is compound interest

Compound interest is calculated on both the principal and any accumulated interest from prior periods. In other words, it generates "interest on interest." It leads to exponential growth, where the amount increases at a progressively faster rate.

Concept of compound interest

Compound interest accelerates growth by reinvesting the earned interest back into the principal amount. Now, interest for the next period is calculated on an increased principal.

The compound interest formula is as stated below.

• Compound interest = P (1 + R/100)^t

Where, P is the principal amount, R is the annual interest rate and t is the number of years.

Let's take an example of Rs. 1 lakh invested at 5% annual interest. But this time, we will compound the interest annually.

Year 1

• Principal = Rs. 1,00,000
• Interest at 5% on Rs. 1 lakh = Rs. 5,000
• At the end of Year 1, the Rs. 5,000 interest earned is reinvested.

Year 2

• Principal = Rs. 1,00,000 + Rs. 5,000 interest earned in Year 1 = Rs. 1,05,000
• Interest at 5% on Rs. 1,05,000 = Rs. 5,250

The compounding effect has now started. Despite the same interest rate, you earn Rs. 250 more in Year 2 since the interest was reinvested and the principal increased.

What is the difference between simple and compound interest?

Compound interest generally offers higher returns over time due to its exponential growth. Some of the key differences are:

Calculation base: Simple interest is calculated only on the original principal, while compound interest is calculated on both the principal and accumulated interest

Growth pattern: Simple interest grows linearly, whereas compound interest grows exponentially.

Feature	Simple Interest	Compound Interest
Definition	Calculated only on the principal amount.	Calculated on the principal amount and accumulated interest.
Calculation Basis	Constant throughout the loan or investment period.	Changes with each compounding period.
Growth Pattern	Linear growth.	Exponential growth.
Formula	Simple Interest = Principal × Rate × Time	A = P(1 + r/n)^(nt)
Interest on Interest	No.	Yes.
Potential Returns	Relatively lower.	Potentially higher, especially over long periods.
Common Use Cases	Short-term loans, some fixed-income investments.	Long-term investments, savings accounts, credit card balances.
Impact of Compounding Frequency	Not applicable.	Higher compounding frequency leads to faster growth.

Potential for growth - Simple interest vs compound interest

To clearly demonstrate the difference compounding makes, let's compare simple vs compound interest growth using a compounding calculator.

Example 1

• Principal: Rs. 1 lakh
• Interest rate: 10% p.a.
• Period: 10 years

Simple interest: Total interest earned = 1 lakh x 10% x 10 years = Rs. 1 lakh

End value after 10 years = Rs. 1 lakh (original principal) + Rs. 1 lakh (interest) = Rs. 2 lakh

Compound interest: End value after 10 years = Rs. 2.59 lakh

Example 2

Let's increase the period to 20 years.

• Principal: Rs. 1 lakh
• Interest rate: 10%
• Period: 20 years

Simple interest: Total interest = Rs. 2 lakh

End value = Rs. 3 lakh

Compound interest: End value = Rs. 6.73 lakh

Example 3

Now let's look at monthly investments.

• Monthly investment: Rs. 5,000
• Interest rate: 10%
• Period: 20 years

Simple interest: Total invested = Rs. 12 lakh

Total interest = Rs. 2.40 lakh

End value = Rs. 14.40 lakh

Compound interest: End value = Rs. 43.08 lakh

Here we see the power of regular investing and compounding.

Examples using calculator: Simple interest vs compounding

To easily compare simple and compound interest, you can use online calculators.

• Simple interest calculator - Allows calculating simple interest based on principal, rate, and time.
• Compound interest calculator - Allows calculating compound interest by entering principal, rate, time, and compounding frequency.

The calculators provide an easy way to determine the huge difference compounding can make versus simple interest.

For instance, if Rs. 10,000 invested for 10 years at 8%, the following will be the results.

• Simple interest calculator shows total interest earned as Rs. 8,000.
• Compound interest calculator shows the total amount after 10 years as Rs. 21,589.

The difference between compound interest and simple interest with compounding calculators is that compound interest calculates interest on the initial principal and on accumulated interest from previous periods, while simple interest only calculates interest on the original principal amount.

Which is better: Simple Interest vs Compound Interest?

The impact of compound interest depends upon whether one is investing or borrowing. When applied to investments, compound interest accelerates the growth of the principal amount, as interest is calculated on both the initial investment and the accumulated interest. This exponential growth can significantly amplify return potential over time. Conversely, when applied to loans, compound interest can rapidly increase the total loan repayment amount, as interest is calculated on both the principal amount and the accrued interest.

How Interest Affects Your Money Over Time

Interest, whether simple or compound, plays a significant role in determining how money accumulates.

Simple interest's steady growth: With simple interest, earnings increase at a fixed and predictable rate. This happens because interest is always calculated on the original principal amount. While this provides certainty, it generally results in lower potential growth compared to compound interest, particularly over long periods.

Compound interest's accelerating effect: Compound interest enables money to grow at an increasing rate over time. As interest accumulates, it is added to the principal, and future interest is calculated on this increased amount. This compounding effect can significantly enhance financial growth.

Impact of inflation: Inflation reduces the purchasing power of money. To achieve real financial growth, investment returns must surpass inflation. While an investment may show positive returns, if the rate of return is lower than inflation, its actual value may decline over time.

The advantage of time: The longer money remains invested, the greater the impact of compound interest. Starting early allows investments to benefit from long-term compounding effects.

Common Myths About Simple and Compound Interest

Myth 1: Simple interest is always preferable because it is easier to understand.

Reality: While simple interest is straightforward, compound interest provides significantly higher potential returns over time.

Myth 2: Only individuals with substantial wealth benefit from compound interest.

Reality: Compound interest benefits everyone, regardless of income level. Regularly investing small amounts from an early stage can result in significant financial accumulation.

Myth 3: The frequency of compounding has little impact.

Reality: More frequent compounding (e.g., daily instead of annually) enhances financial growth more rapidly.

Myth 4: All debts use simple interest.

Reality: Many types of debt, such as credit card balances and mortgages, apply compound interest, which can cause debts to accumulate quickly if not managed effectively.

Myth 5: Interest rates are the sole determinant of financial growth.

Reality: While interest rates matter, factors like time, compounding frequency, and inflation significantly influence overall financial outcomes.

Additional points to know

• Start investing early with an aim to benefit most from compounding.
• Larger investments mean higher compound interest income.
• Regular, disciplined investments work best for wealth creation.
• Opt for the highest compounding frequency possible.
• Reinvest all interest, dividends earned to benefit from compounding.
• Review investments periodically and reinvest matured amounts.

Conclusion

Compound interest can make your money grow exponentially over time due to the reinvestment of earned interest. Using the power of compounding is key to long-term wealth creation. A lumpsum calculator mutual fund can also be a practical tool for those considering a lumpsum investment in a mutual fund. It factors in the power of compounding and helps you estimate the potential growth of your investment over time.

FAQs

Which is better - simple or compound interest?

Compound interest is better due to reinvestment of interest and exponential growth over long periods.

When should I choose simple interests?

For short term investments like Fixed Deposits of 3–6-month duration.

How frequently should compound interest be calculated?

More frequent compounding is better - monthly or quarterly is preferable over annual.

What is maturity value?

The maturity value is the total amount an investor receives at the end of an investment term. It includes the initial principal amount, plus accumulated interest or returns (if any) earned during the investment period. The maturity value is determined by factors like the initial investment amount, interest rate, and the duration of the investment.

Why is compound interest used?

Compound interest is a powerful financial tool that allows investors to earn returns not only on their initial investment but also on the accumulated interest over time. This creates a compounding effect, where the earnings from one period are reinvested to generate further earnings in the next period.

What is the principal in simple interest?

The principal is the amount originally invested by the investor. Simple interest is a straightforward method of calculating interest on a principal amount. The principal remains constant throughout the loan or investment term, and interest is calculated solely on this initial amount. This makes simple interest a relatively simple way to determine the cost of borrowing or the return on an investment.

What is the formula for the amount if it is compounded annually?

The formula for annual compounding is A = P (1 + R/100)^n, where A represents the amount, P is the principal, R is the annual interest rate, and n is the time in years. For example, a Rs 10,000 investment at 10% annual interest for 3 years becomes Rs 13,310.

What's the difference between CI and SI?

Simple interest (SI) and compound interest (CI) differ in how interest is calculated. SI applies only to the principal, growing at a constant rate, while CI factors in accumulated interest, leading to exponential growth. SI suits short-term loans, while CI benefits long-term investments like savings accounts, fostering potential wealth accumulation.

What is the difference between simple interest and fixed interest?

Simple interest is calculated only on the original principal, remaining constant throughout. Fixed interest refers to an unchanging rate over time, but the interest amount can vary with compounding. For example, fixed deposits with fixed rates often use compound interest for returns.

Do mutual funds earn compound interest?

Mutual funds do not earn interest, they earn market-linked returns. The rate is not fixed and depends upon market conditions. However, by reinvesting returns and income and staying invested for the long-term, a compounding-like effect takes place as your returns earn additional returns, potentially resulting in significant growth over time. Tools such as an SIP calculator online and a lumpsum calculator can help you visualise this potential impact of compounding on your investments.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.