Compound Interest vs. Simple Interest
Simple InterestSimple interest refers to applying the interest rate on the principle amount of an investment or loan and is very straight forward to calculate. With simple interest you would only apply the interest rate to whatever the principle balance is, and that gives the interest amount.
In a situation with a $100,000 loan with a 5% simple interest rate, you would have a $5,000 ($100,000 x .05) interest expense.
Compound InterestCompound interest refers to applying the interest rate not only on the principle amount of and investment or loan but also on the interest that has accrued over time. This means that the overall interest expense (or income) can be significantly greater depending on how often it is compounding.
In a situation with a $100,000 investment with a 5% interest rate that compounds quarterly, you would have 1.25% being charged on the total balance (including accumulated interest) each quarter. The results would be:
- Quarter 1 ($100,000 * .0125) = $1,250
- Quarter 2 ($101,250 * .0125) = $1,266
- Quarter 3 ($102,516 * .0125) = $1,282
- Quarter 4 ($103,798 * .0125) = $1,298
- Total Interest = $5,096
Compound Interest vs. Simple InterestSimple interest rates do provide the benefit of being very transparent and easy to calculate, with both parties clearly knowing what the income and expense will be. Compound interest can be a good or bad thing depending on which side of the transaction you are on (and whether the compound benefits you or costs you). The downside is that it can be very difficult to calculate and will often require sophisticated financial models accounting for various inputs like the compounding rate and the timing of different cash transactions.
By Jeffrey Glen