Learn Compound vs. Simple Interest

by Gily Tenorio on July 7, 2010

in Financial Education 101

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, for example you made a loan in a bank so there’s a certain amount of money you need to pay aside from the principal amount. Interest also can beĀ  money earned by deposited funds. The most common example of this is the interest we get from our savings account. Typical interest rate of a savings account ranges from 0.5 to 1.5% per year.

There are two most popular kinds of interest, simple or compound interest.

Simple interest

Simple interest is an interest on a principal sum, not compounded on earned interest, or on that portion of the principal amount that remains unpaid.

The amount of simple interest is calculated according to the following formula:

Is = r*P*t

where r is the period interest rate, P the initial balance and t the number of time periods elapsed.

To calculate the period interest rate r, one divides the interest rate I by the number of periods t.

Compound interest

A compound interest is a type of interest which is calculated not only on the initial principal but also the accumulated interest of prior periods. Compound interest is almost the same to simple interest; but, with time, the difference becomes bigger.

Albert Einstein once said: “The most powerful force in the universe is compound interest.”

To compute for compound interest use the following formula,

Ic = P0 *[(1+r)^t-1]

Pt = P0 + Ic

where Ic is the compound interest, P0 the initial balance, Pt the balance after t periods (where t is not necessarily an integer) and r the period rate.

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Venkatayuvaraju September 25, 2010 at 02:32

It is nice to see the formulas for SI and CI, but it would be more helpful to others(including me), if the formulas could have been executed with some examples as step by step.

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