Compound vs. simple interest: Understanding concepts and difference with a 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

1. Concept of simple interest
2. Concept of compound interest
3. Potential for growth - Simple interest vs compound interest
4. Examples using calculator - SI vs compounding calculator
5. Which Is Better, Simple or Compound Interest?
6. Additional points to know

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: Simple interest vs compounding

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.

Which is better, simple interest or compound interest?

The impact of compound interest depends upon whether one is investing or borrowing. When applied to investments, compound interest accelerates the growth of the principal amount, as interest is calculated on both the initial investment and the accumulated interest. This exponential growth can significantly amplify return potential over time. Conversely, when applied to loans, compound interest can rapidly increase the total loan repayment amount, as interest is calculated on both the principal amount and the accrued interest.

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 supported by tools like a SIP calculator online, is key to long-term wealth creation. A lumpsum calculator mutual fund can also be a practical tool for those considering a lumpsum investment in a mutual fund. It factors in the power of compounding and helps you estimate the potential growth of your investment over time.

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.

What is maturity value?

The maturity value is the total amount an investor receives at the end of an investment term. It includes the initial principal amount, plus accumulated interest or returns (if any) earned during the investment period. The maturity value is determined by factors like the initial investment amount, interest rate, and the duration of the investment.

Why is compound interest used?

Compound interest is a powerful financial tool that allows investors to earn returns not only on their initial investment but also on the accumulated interest over time. This creates a compounding effect, where the earnings from one period are reinvested to generate further earnings in the next period.

What is the principal in simple interest?

The principal is the amount originally invested by the investor. Simple interest is a straightforward method of calculating interest on a principal amount. The principal remains constant throughout the loan or investment term, and interest is calculated solely on this initial amount. This makes simple interest a relatively simple way to determine the cost of borrowing or the return on an investment.

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