Simple interest vs. Compound interest: Formula & difference between with examples

The interest rate on fixed deposits, whether provided by a financial institution, a government enterprise, or a private corporation, is calculated in two ways. The first is simple interest, and the second is compound interest.

Both types of interest are calculated only on the principal investment, but they differ in their consideration of the principal amount. This leads to a difference in the amount of return received by the investor at the end of their investment tenure.

Keep reading to understand the critical differences between these two types of interest calculations.

Definition of Simple and Compound Interest

• Simple interest is calculated on the initial principal amount for each period.
• Compound interest is calculated on the principal amount as well as on any interest that has been added to it, resulting in interest being earned on interest.

Simple Interest and Compound Interest Formula

Simple interest is calculated using the formula SI = P × R × T/100 , where:

P is the principal amount

R is the annual interest rate

T is the time period

Compound interest is calculated using the formula CI = P× (1 + R/n) ^ n×T  − P, where:

P is the principal amount

R is the annual interest rate

n is the number of times interest is compounded per year

T is the time period

What is the Difference Between Simple and Compound Interest?

In the long run, compound interest returns are typically higher than simple interest returns due to the former’s exponential growth. The key difference between the two lies in the calculation method. The calculation of simple interest is based on the original principal, whereas the calculation of compound interest is based on both the principal and accumulated interest.

Here’s a table summarizing the difference between simple and compound interest.

Simple Interest vs Compound Interest Examples

Simple interest example

Suppose you invest Rs. 10,000 at a 5% annual interest rate for 3 years. Using the simple interest formula, the total amount after three years will be:

SI = P x R x T/100

SI = 10,000 x 5 x 3/100 = Rs. 1,500

Compound interest example

Now, consider the same Rs. 10,000 investment at a 5% annual interest rate, but this time compounded annually for 3 years. Here, interest is calculated on the principal plus any accumulated interest. Using the compound interest formula, the interest earned after 3 years will be:

CI = P x (1 + R/n) ^ n x T − P

CI = 10,000 × (1 + 5%)^3 - 10,000 = Rs. 1,576.25

How Does Interest Affect your Money Over Time?

Interest, simple and compound, has the following effects on the way your money accumulates. 

• Linear growth with simple interest: Simple interest grows your money at a fixed and expected rate because interest calculation is always on the original principal amount. You are certain about the effect of interest on your money. However, the growth potential in simple interest is lower than that of compound interest, especially over long periods.
• Accelerating growth with compound interest: In the case of compound interest, money grows at an exponential rate over time. The accumulated interest is added to the principal, and the interest estimation is then on the increased amount. This compounding effect boosts financial growth substantially.
• Beating inflation: The purchasing power of money diminishes due to inflation. Achieving financial growth goals requires investment returns that exceed inflation. If the return from an investment is positive but it doesn’t beat inflation, its actual value may fall in the long term.
• Benefit of investment time: The compound interest you earn increases if you remain invested for a long time. So, to enjoy long-term compounding effects, you must start investing early.