Interest is the cost of borrowing money, where the borrower pays a fee to the owner for using
the owner's money. The interest is typically expressed as a
percentage and can be either simple or compounded. Simple interest is
only based on the principal amount of a loan, while compound interest is based on the principal amount and the accumulated interest.
Simple interest
is calculated by multiplying the principal amount by the interest rate
and the number of periods in a loan. Generally, simple interest paid or
received over a certain period is a fixed percentage of the principal
amount that was borrowed or lent. For example, a student obtains a
simple interest loan to pay one year of her college tuition, which costs
$18,000, and the annual interest rate on her loan is 6%. She repaid her
loan over three years and the amount of simple interest she paid was
$3,240 = $18,000 x 0.06 x 3. The total amount she repaid was $21,240 =
$18,000 + $3,240.
Conversely, compound interest,
is interest on interest. It is calculated by multiplying the principal
amount by the annual interest rate raised to the number of compound
periods. As opposed to simple interest, compound interest accrues
on the principal amount and the accumulated interest of previous
periods. For example, if the student introduced above obtained a
compound interest loan for college. The amount of compound interest that
would be paid is $18,000 x ((1.06)3- 1) = $3,438.29, which
is higher than the simple interest of $3,240. This is because unlike the
simple interest, the compound interest accrues on both the principal
and the accumulated interest.
Go deeper into the amazing concept of compounding here - Investing 101: The Concept of Compounding.
