There are two different ways of calculating interest -- simple and compound. Here's how to calculate each, as well as the key differences and similarities between the two.
Simple interest is well, simple. Each year, the interest is calculated as a percentage of the principal, as follows:
So if you borrow $1,000 at 7% simple interest for five years, you'll owe $350 in interest.
In the real world, simple interest is rarely used. When you deposit money into an interest-bearing account, or take out a line of credit, the interest that accumulates is added to the principal, and the next interest calculation is done on both the principal and the interest.
Interest can be compounded at any interval, but the most common compounding intervals are
- Annual: once per year.
- Quarterly: four times per year
- Monthly: 12 times per year
- Weekly: 52 times per year
- Daily: 365 times per year
To calculate compound interest over a set period of time, the following mathematical formula is used:
Where P is the principal, r is the interest rate (expressed as a decimal), n is the number of times per year interest is compounded, and t is the length of time in years.
For example, if you deposit $1,000 in a five-year CD at 4% interest that compounds monthly, you can use the above formula to calculate the interest:
Similarities and differences
While both types of interest will grow your money over time, there is a big difference between the two. Specifically, simple interest is only paid on principal, while compound interest is paid on the principal plus all of the interest that has previously been earned.
As an investor or depositor, you definitely want to earn compound interest, as it adds up greater over time. In the example of the $1,000 five-year CD at 4%, a simple interest calculation would produce $200, $21 less than the monthly compounding.
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