Difference Between Compound and Simple Interest

Interest rates are fundamental to any investment instrument, determining how your funds will grow over time. Whether your investments offer simple or compound interest returns will considerably influence the overall returns. As a result, the interest rate is what you should check first before considering any investment. 

Spend a few minutes to learn about simple vs compound interest rates to uncover their key differences. Explore our guide on simple interest and compound interest. 

Difference Between Simple and Compound Interest

Here are the main differentiating factors influencing simple and compound interest returns:

• Interest Levied

When you are promised to receive simple interest income, the applicable rate is calculated on the principal alone. Whereas, compound interest results from the accrual of interest on your contribution as well as the previously accumulated interest amount.

• Returns

In the long run, deposits with compound interest are always going to give you more returns compared to simple interest schemes. However, for this strategy to be effective, both plans must have identical tenures and interest rates.

• Growth

Because of the interest-on-interest principle, compound interest investments provide you with exponential growth of wealth. This nature is unlike the linear nature of simple interest plans, which makes the latter option least popular among investors. 

• Impact of Principal Invested

For both simple and compound interest, the principal amount plays a vital role in determining earnings. However, the impact of the principal is magnified over time for compound interest investments due to the compounding effect.

Difference Between Simple Interest and Compound Interest Formula

To find the returns of any type of investment, such as a fixed deposit, you can use both simple and compound interest calculators found online. These tools are very easy to use. All you have to do is enter your principal amount, rate of interest and tenure of investment. 

Next, the calculator gives you the exact maturity amount along with the total accrued interest. It is highly recommended that these tools be used as they help avoid human errors. 

However, we have provided separate formulas for both simple interest and compound interest calculations here to help you understand how an online calculator works in the background.

Simple Interest Formula

To calculate simple interest, apply this formula: 

Simple interest = (P*R*T)/100

Here, P stands for the original sum or principal invested. Next, R and T refer to the rate of interest per month/ year and tenure of investment, respectively. 

Compound Interest Formula

Similarly, there is a different formula to compute compound interest:

Compound interest = P(1 + r/n)^(nt) - P

In this formula, P represents your principal, n is the number of times your investment is compounded in a year, r is the annual rate of interest, and finally, t is investment tenure. 

Benefits of Compound Interest Over Simple Interest

It is often discussed that compound interest is far superior to simple interest, as it allows investors to benefit from the power of compounding. But what exactly is this compounding effect? 

You can think of compounding like a snowball rolling downhill. It starts small, but as it gathers more snow and momentum, it starts to grow larger and faster. Similarly, your compound-rate investments grow exponentially over time, with the interest earning interest on itself.

Additionally, there are other major benefits of compound interest, such as:

• It Is Great for Long Term

Compound interest is a very powerful tool for long-term wealth accumulation. By reinvesting earnings over time, your initial investment grows exponentially. This makes it ideal for long-term financial goals like retirement or buying a house.

• Compound Interest Investments Are Safe

Many compound interest investments, such as fixed deposits, government bonds and index funds, are considered safe. These investments offer steady returns over time, minimising the risk of significant loss.

• It Instils a Saving Habit Over Time

Seeing your investment grow steadily can motivate you to save more regularly. This disciplined approach to saving leads to a significant increase in your overall wealth.

• It Creates a Safety Net for Unexpected Expenses

A well-established compound interest investment serves as a financial safety net. It helps you meet unforeseen costs, such as medical emergencies or job loss, without depleting your emergency fund.

• Compound Interest Makes Your Financial Goals Reality

Compound interest can help you achieve your lifetime goals faster. By consistently investing and letting your money grow, you can reach milestones like buying your first car, starting a business, or retiring early.

• You Can Outrun Inflation 

With compound interest working for you, you can effortlessly maintain your purchasing power over the years. This is because you successfully create a roadmap where you keep on passively earning returns that exceed the inflation rate. 

That said, a well-crafted portfolio of compound interest investments can strategically help anyone achieve their financial objectives. For further guidance on this journey, one may seek the help of financial experts, too, particularly when they are starting out.

On the Stable Money app, you can find fixed deposit schemes that are tailored for different users. Consider adopting these investment avenues so that you plan one step towards your financial goal at a time.