What is the difference between compound and simple interest?

Assume you make a deposit into a bank account:

SIMPLE INTEREST

If the Bank pays you simple interest the interest payment each year will be the same and will be the interest rate times the initial amount

Simple interest refers to interest earned only on the original capital investment amount.

FV = PV(1 + r n)

(Eg $100 for 3 years at 10% Simple Interest will accumulate to $130)

COMPOUND INTEREST

If the bank pays you compound interest you will receive interest payments not just on the initial amount but also on previous interest payment

In finance it is almost always compound interest that is used

Compound interest refers to interest earned on both the initial capital investment and on the interest reinvested from prior periods

FV = PV(1 + r ) n

Example:

For $100 invested at 10% for 3 years: 

Compound interest: 

The accumulated value of this investment at the end of three years can be split into two components:

1. Original principal: $100

2. Interest earned: $33.10

Simple Interest:

1. Original principal: $100

2. Interest earned: $30

The other $3.10 is from compounding that is, interest on interest

Having issues with your finance module? SMS us at +65 9758-7925 or email: enquiry@starcresto.com