Simple interest and compound interest are two methods of calculating interest, typically used in investing, loans, and other financial areas.
Simple Interest is calculated only on the initial amount (principal) that you invested or loaned. This means the interest does not compound over time. The formula used to calculate simple interest is Principal x Rate x Time.
Compound Interest, on the other hand, differs as it calculates interest on the initial principal as well as the accumulated interest of previous periods. In essence, you earn interest on your interest. This method can significantly increase the growth of an investment or the cost of a loan over time. The formula to calculate compound interest depends on the frequency of compounding and can be slightly complex. But the basic idea is to add the interest earned in one period to the principal for calculating the interest in next periods.
In general, you will earn more over time with compound interest compared to simple interest, all else being equal. That’s why compounding is often called the ‘eighth wonder of the world’ in finance. The difference becomes more pronounced the longer the time period involved.
