Picture two trees that you have planned to grow in your garden.
(A) One way is that you have planted a tree that is growing every year at a fixed rate. Let’s say it grows one foot each year, no matter how big it has grown. It gives you exactly 10 apples every year, no matter how well it flourishes or how much maintenance it receives. You are happy that you are getting fruit.
(B) The second way is that you have planted a tree that is growing every year at a different rate. In one year, it produces 10 apples; in the second year, it produces 20; in the third year, it produces 30 apples; and so on. The tree is produced at a different rate with a different number of fruits every year. Every year, you get more than 10 apples.
Simple interest and compound interest are like trees A and B. Both methods yield interest. In simple interest, there is a fixed amount or return that you are receiving every time, and compound interest grows on interest, leading to substantial growth over time.
Table of Contents
Simple interest and compound interest
Simple interest: Simple interest is calculated on the original principal amount owed to the borrower. It has a fixed interest rate over a period of time, which does not change. It provides easy, steady, and predictable returns over time.
Compound interest: Compound interest, on the other hand, grows upon the purchase amount and accumulates over time. Compounding multiplies over the initial amount, accelerating the growth of invested funds. It can be expressed as interest growing on interest!
The formula for calculating simple and compound interest.
Simple Interest (SI);
The formula for calculating simple interest is:
SI = P × R × T
where:
P = principal amount (the initial amount)
R = annual interest rate
T = period/loan duration (years)
For example, you have planted the apple tree with an initial amount (P) that produces 10 fixed amounts of apples (interest rate) with every passing year (T).
Planted trees amount(Principal amount)= INR 100
Interest rate(R)=10% per year
Time (T)= 3 years
SI = P × R × T
=1001030/100
=100 (initial) + INR30 (interest)
= INR130 total after 3 years.
So,after 3 years, you have INR130, just by letting it grow at 10% per year!
Compound interest;
Compound interest compounds on the initial principal amount and the interest levied on the investment. Unlike simple interest, which is calculated based upon the initial principal amount, compound interest accumulates on the initial investment plus all the previously earned internet. The investment grows at a faster rate as interest earned on the original investment and accumulated internet.
A = P (1 + r/n)^(nt)
- Where A stands for the future value of the investment (including interest and loans),
- P is the principal investment amount (the initial investment amount).
- r is the annual rate of interest (decimal).
- n is number of times interest is compounded per year or per period
- t is the period of time, money is being invested.
For example,you have planted the apple tree with an initial amount (P) that produces 10 apples (interest rate) and that too on a compounding basis.
1st year
Interest = 10 apples (10% of 100)
Total apples = 100 + 10 = 110 apples
2nd year
Interest = 11 apples (10% of 110)
Total apples = 110 (from 1st year) + 11
= 121 apples
3rd year
Interest = 12.1 apples (10% of 121)
Total apples = 110 (1st year) + 11 (2nd year) + 12.1
= 133.1 apples
So,after 3 years, you have a total of 133.1 apples.
Each year the amount of apples (interest) grows over the initial amount.
Hence, we can see that the compound interest has given the high return than the simple interest.
Features and key differences
The interest rate can be calculated using two methods: simple interest or compound interest.
Interest rates
- Simple interest is based on the original amount at the beginning of the loan. It is always calculated on the basis of the initially given amount by the lender to the borrower. The interest rate is fixed and does not change over time.
- Compound interest is calculated based on the accumulated amount over time and the interest levied on it. The interest rate is not fixed. It changes every year. The interest rates compound over the initial amount, which accelerates the growth.
Management
- Simple interests are easy to calculate.It is a simple and straightforward method to calculate interest for those who are looking for easy management.
- Compound interest is more complex to understand and requires more management.
Growth
- Simple interests are linear in nature. They grow in a similar pattern over the years and provide predictable and easy returns on investment.
- Compound interest grows exponentially. It earns interest on reinvested amounts. The amount is always increasing, multiplying the previous profit.
Application
- Simple interest is available for some short-term loans. Simple interest based loans are automobile loans, bonds, and often short-term personal loans, which borrowers can use for any personal reasons. It can cover education loans, medical expenses, buying home accessories, etc. Mortgages, like amortization schedules, also involve using simple interest.
- Savings accounts and long-term loans calculate interest using compound interest. Credit cards and financial institutions also use compound interest, where profit is made from faster growth on accumulated interest.
Compounding frequency
- There is no reinvestment of interest in simple interest. Fixed interest rates are calculated once a year.
- Compound interest can be compounded at different frequencies. They can be compounded monthly, quarterly, annually, semiannually, or daily.
Simple interest and compound interest: which is better?
Let’s consider the tree you planted in your backyard, which is growing every year with branched branches, thus supporting more fruit over time. As the seasons pass, the tree is stronger and produces more fruit than before. The tree is building on its foundation; your interest is that this tree will allow your fund to grow on itself. The longer you leave it undisturbed, the faster it grows.
Simple Interest, on the other hand, provides, like a tree, which provides you with a fixed amount of fruit every year. It offers you predictable and consistent returns every year.
Simple interests
Advantages
- Offer you predictable and consistent returns on short-term investments.
- It helps with easy management for browsers with limited budgets.
- Easy to manage and simple to understand.
- Easy repayments allow you to clear loans easily with a simple strategy.
Disadvantages
- Fixed interest rates and limited flexibility inhibit you from adjusting to market conditions.
- It may be troublesome if you are a borrower since companies can rely on high interest rates to profit from short-term investments.
- Lower returns are due to a lack of compounding. Fixed interest rates may not benefit investments much.
Compound interest
Advantages
- Depending on whether you are a lender or a borrower, compounding can be beneficial for you.
- Compounding allows you to grow money faster and at a quicker rate.
- Exponential growth on the initial amount and reinvestment over time.
Disadvantages
- Complex in nature, management cannot be easy for everyone.
- Higher cost of interest if you are borrowing.
In conclusion, simple securities and compound interest have pros and cons in a given scenario. Depending on the terms of the investment and personal goals and strategies, both can benefit lenders and borrowers.
Interest is a powerful financial tool, so familiarizing oneself with the basic concepts is important before making major decisions.
Please share your thoughts on this post by leaving a reply in the comments section. Also, check out our recent post on: “How to Use Liquid Funds for Emergency Fund Management.”
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Disclaimer – This article is for educational purposes only and by no means intends to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.
