Question

What is the key difference between simple interest and compound interest, and how does this difference affect the effectiveness of each?

Answer 1

Answer:

The simple interest is calculated only on the principal amount of a loan so it is relatively easier to calculate than the compound interest.

The compound interest is calculated on the principle amount plus the interest that the amount gets per compounding period up to the period of the loan. In other words, in compound interest we get, interest on interest.

This difference between the both, is the reason, we get more money in compound interest than simple one.

Let us take an example-

Suppose the principle is = $5000

r = 5% or 0.05

t = 5 years

Simple interest formula is :

$p\times r\times t$

=> $5000\times0.05\times5=1250$

So, total amount after 5 years will become = $5000+1250=6250$ dollars.

-----------------------------------------------------------------------------------------

Lets check for compound interest where the interest is compounded annually.

p = $5000

r = 5% or 0.05

t = 5 years

n = 1

Compound interest formula is :

$A=p(1+\frac{r}{n} )^{nt}$

$A=5000(1+\frac{0.05}{1} )^{5}$

=>$A=5000(1.05)^{5}$

A = $6381.40

--------------------------------------------------------------------------------------------

We can see that we are getting more money in compound interest than the simple interest, for the same amount and same time period.