Everyone is familiar with the concept of interest, whether they are earning it on their investments or paying it on their debts. Simple interest and compound interest are two different types of interest and understanding the difference between the two can be very important.
Definition of Simple Interest
Simple interest is the application of an interest rate on the principal amount of an investment or loan, and it is relatively simple to compute. With simple interest, you would only apply the interest rate to whatever the principle balance is, and that gives the interest amount.
In a situation with a $100,000 loan with a 5% simple interest rate, you would have a $5,000 ($100,000 x .05) interest expense.If after one year you have paid interest as well as $10,000 of principle your interest expense would be $4,500 ($90,000 x .05).
Definition of Compound Interest
Compound interest refers to applying the interest rate not only on the principal amount of an investment or loan but also on the interest that has accrued over time. This means that the overall interest expense (or income) can be significantly greater depending on how often it is compounding.
In a situation with a $100,000 investment with a 5% interest rate that compounds quarterly, you would have 1.25% being charged on the total balance (including accumulated interest) each quarter. The results would be:
- Quarter 1 ($100,000 * .0125) = $1,250
- Quarter 2 ($101,250 * .0125) = $1,266
- Quarter 3 ($102,516 * .0125) = $1,282
- Quarter 4 ($103,798 * .0125) = $1,298
- Total Interest = $5,096
So with compound interest, a higher interest amount is generated, and the more frequent the compounding period the higher the interest will be. This is very important as a 5% rate compounded monthly or quarterly will generate a very different result than if it is compounded daily. Daily or weekly compounding rates on some forms of debt are one way where someone can be unpleasantly surprised and see their debt spiraling out of control. When reviewing the terms of your debt and interest-bearing investments you want to make sure you carefully review the details and compounding rates to avoid any surprises.
Difference between Simple Interest vs. Compound Interest
The key difference between simple Interest vs. compound interest is that simple interest rates do provide the benefit of being very transparent and easy to calculate, with both parties clearly knowing what the income and expense will be. While compound interest can be a good or bad thing depending on which side of the transaction you are on (and whether the compound benefits you or costs you). The downside is that it can be very difficult to calculate and will often require sophisticated financial models accounting for various inputs like the compounding rate and the timing of different cash transactions.