Compound vs. Simple Interest

Compound vs. Simple Interest is a concept that at first seems terrifying, but when examined under the light is as harmless as a hamster.

Before we dive into the definitions of and differences between compound and simple interest, it is important to understand what is, exactly, interest.


Interest is a word with many meanings. It is my hope that this article peaks your interest. And if you want to expand your knowledge on finance and accounting, it is in your best interest to continue on with this article, no matter how complex the concept gets. But for our purposes, I imagine you are interested in this article because you want to learn more about interest as it relates to money.


A brief history on the concept of interest:

Interest, in the most basic sense, is the cost of borrowing a good. The historian Paul Johnson traces the concept back to 5000 years before Christ, where Middle Eastern Civilizations charged food for the borrowing food. If I loan you three pieces of bread for a day and charge you one loaf per day, then come the second day you have to pay me back the 3 loaves I loaned you + one loaf.

In the classical period, charging interest was prohibited. This was so because the beliefs at the time outlawed the charging of interest. The renaissance is where we first see the concept really begin to evolve. People began to realize that they could make good money by loaning what they had to other people. Borrowers realized that if the borrowed enough, they could produce a surplus of a particular good, repay the loan, and then make money from the surplus!

That is a brief history. Before we dive into simple and compound, lets discuss the terms associated with borrowing.

Typically interest is charged over an extended period of time. In the modern world, you have schedules that outline the terms. For example, lets say you want you buy a house for $100,000. I will loan you $100,000 with a 6% interest rate that you will have to pay back in full in 6 years. The $100,000 that I loan you is called principal. The 6% you pay on that principal is called the interest rate. In this case we will say that interest accrues semi-annually. This means that every 6 months you will pay me 6% of whatever the principal is. Usually people pay back principal with interest so they reduce the total amount of what they owe, thereby reducing the interest charges.

So if interest is the cost of borrowing, and we know the meaning of principal and interest rate what then is simple and compound interest? 


Simple Interest

Simple interest is interest charged only on the original principle over an extended time. Simple interest is quite simple to understand. For example, I loan you $10,000 at 7% interest that is due in 2 years with interest charged annually. At the end of 2 years you owe me $11,400. $700 of interest in the first year + $700 of interest in the second year. The interest is charged only on the original principal


Compound Interest

Compound interest is different from simple in that it adds previous interest payments to the principal and charges interest on that amount. Using the previous example...

The loan is $10,000 at 7% interest over 2 years. At the end of year one you owe me $700. At the end of year two, you owe me $749. After you've repaid principal, you will have paid me $11449.

Compound interest adds (compounds) the interest payments from previous years to the principal amount to get a new interest payment.

In summary, if you ever have the option between borrowing with simple interest or with compound, take the simple!





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