Compound interest vs. simple interest: Understanding the difference with a compounding calculator
When you invest your money or put it in a savings account, the additional income earned is known as interest. There are two main ways in which interest can be calculated - simple interest and compound interest. On the surface, both methods seem similar since they can help you earn more than your original capital. However, compound interest has the potential for your money to grow significantly faster compared to simple interest. Read on to learn more.
- Table of contents
- Concept of simple interest
- Concept of compound interest
- Potential for growth - Simple interest vs compound interest
- Examples using calculator - SI vs compounding calculator
- Difference between mutual fund shareholders and mutual fund investors
- Additional points to know
- FAQs
Concept of simple interest
With simple interest, the interest is calculated only on the original principal amount invested. For example, if you deposit Rs. 1 lakh in a bank FD with 5% annual simple interest, you will earn Rs. 5,000 as interest every year.
The simple interest formula is as stated below.
- Simple interest = principal x interest rate x time
Example:
- Simple interest = 1,00,000 x 5% x 1 year = Rs. 5,000
The key aspects are as listed below.
- Interest accrues only on the original invested principal.
- The interest rate remains fixed.
- Interest earned is not reinvested to generate further gains.
Concept of compound interest
Compound interest accelerates growth by reinvesting the earned interest back into the principal amount. Now, interest for the next period is calculated on an increased principal.
The compound interest formula is as stated below.
- Compound interest = P (1 + R/100)^t
Where, P is the principal amount, R is the annual interest rate and t is the number of years.
Let's take an example of Rs. 1 lakh invested at 5% annual interest. But this time, we will compound the interest annually.
Year 1
- Principal = Rs. 1,00,000
- Interest at 5% on Rs. 1 lakh = Rs. 5,000
- At the end of Year 1, the Rs. 5,000 interest earned is reinvested.
Year 2
- Principal = Rs. 1,00,000 + Rs. 5,000 interest earned in Year 1 = Rs. 1,05,000
- Interest at 5% on Rs. 1,05,000 = Rs. 5,250
The compounding effect has now started. Despite the same interest rate, you earn Rs. 250 more in Year 2 since the interest was reinvested and the principal increased.
Potential for growth - Simple interest vs compound interest
To clearly demonstrate the difference compounding makes, let's compare simple vs compound interest growth using a compounding calculator.
Example 1
- Principal: Rs. 1 lakh
- Interest rate: 10% p.a.
- Period: 10 years
Simple interest: Total interest earned = 1 lakh x 10% x 10 years = Rs. 1 lakh
End value after 10 years = Rs. 1 lakh (original principal) + Rs. 1 lakh (interest) = Rs. 2 lakh
Compound interest: End value after 10 years = Rs. 2.59 lakh
Example 2
Let's increase the period to 20 years.
- Principal: Rs. 1 lakh
- Interest rate: 10%
- Period: 20 years
Simple interest: Total interest = Rs. 2 lakh
End value = Rs. 3 lakh
Compound interest: End value = Rs. 6.73 lakh
Example 3
Now let's look at monthly investments.
- Monthly investment: Rs. 5,000
- Interest rate: 10%
- Period: 20 years
Simple interest: Total invested = Rs. 12 lakh
Total interest = Rs. 2.40 lakh
End value = Rs. 14.40 lakh
Compound interest: End value = Rs. 43.08 lakh
Here we see the power of regular investing and compounding.
Examples using calculator - SI vs compounding calculator
To easily compare simple and compound interest, you can use online calculators.
- Simple interest calculator - Allows calculating simple interest based on principal, rate, and time.
- Compound interest calculator - Allows calculating compound interest by entering principal, rate, time, and compounding frequency.
The calculators provide an easy way to determine the huge difference compounding can make versus simple interest.
For instance, if Rs. 10,000 invested for 10 years at 8%, the following will be the results.
- Simple interest calculator shows total interest earned as Rs. 8,000.
- Compound interest calculator shows the total amount after 10 years as Rs. 21,589.
The difference between compound interest and simple interest with compounding calculators is that compound interest calculates interest on the initial principal and on accumulated interest from previous periods, while simple interest only calculates interest on the original principal amount.
Additional points to know
- Start investing early with an aim to benefit most from compounding.
- Larger investments mean higher compound interest income.
- Regular, disciplined investments work best for wealth creation.
- Opt for the highest compounding frequency possible.
- Reinvest all interest, dividends earned to benefit from compounding.
- Review investments periodically and reinvest matured amounts.
Conclusion
Compound interest can make your money grow exponentially over time due to the reinvestment of earned interest. Using the power of compounding along with disciplined investments is key to long-term wealth creation.
FAQs
Which is better - simple or compound interest?
Compound interest is better due to reinvestment of interest and exponential growth over long periods.
When should I choose simple interests?
For short term investments like Fixed Deposits of 3–6-month duration.
How frequently should compound interest be calculated?
More frequent compounding is better - monthly or quarterly is preferable over annual.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.