25/04/2022
Simple Interest vs Compound Interest, What You Should Know.
Everyone works with money every day. Balancing your monthly spending or building your budget may require basic arithmetic. And when you start saving, planning for retirement, or need a loan, you will need more mathematics.
Simple Interest
Simple Interest is interest calculated on the principal portion of a loan or the original contribution to a savings account. For example, if you borrowed ₦100,000 from a friend and agreed to repay it with 5% interest, the amount of interest you would pay would just be 5% of ₦100,000: ₦100,000 (0.05) = ₦5,000. The total amount you would repay would be ₦105,000 (the principal plus the interest).
One can easily compute simple interest by multiplying the interest amount with the tenure and the principal amount. Simple interest doesn’t consider the previous interest. It is simply based on the original contributed amount.
Borrowers derive more benefit from simple interest as there is no power of compounding, i.e. there is no interest on interest. However, investors might lose if their investments are based on simple interest.
Formula for Simple Interest
To compute simple interest, multiply the principal amount by interest rate and the tenure. Bear in mind that tenure can be in days, months or years.
S = P*I*N
P = Principal amount
I = Interest rate for the period
N = Tenure
Example:
To understand how simple interest is being computed, let’s take the example of Jennifer who invested ₦1,000,000 in a fixed deposit for a tenure of three years at a 3% interest rate. Using the formula of simple interest, we can calculate the interest Jennifer will earn from the investment.
S = 1,000,000 x 3% x 5 years
S = ₦150,000
For her investment, Jennifer will receive ₦150,000 interest at the end of five years (investment tenure). The bank or the financial institutions pays Jennifer an interest of 5% for using her deposited amount for its operations during the tenure of her investment (three years). Jennifer will receive ₦1,150,000 after the three years duration.
However, if a loan or investment is only for a few days or months, the interest rate must be converted into a daily or monthly basis.
Compound Interest
Compound Interest is the interest on a loan or deposit that accrues on both the initial principal and the accumulated interest from previous periods.
Compound interest is simply when the money you earn starts earning money. Compound interest earns interest on previously earned interest. It is the easiest way to become wealthy.
The bank or financial institution decides on the frequency of compounding. Compounding could be daily, monthly, quarterly, half-yearly or yearly. Accrued interest amount is also subject to the frequency of compounding. Hence, investors benefit from compound interest more than borrowers.
Compound Interest Formula
Compound Interest is calculated by multiplying one plus interest raised to the power of the compounding periods with the principal amount.
A = P (1 + r/n) nt
Where:
A – Compound interest
P – Principal amount
r – Rate of interest
n – Number of compounding periods
t – Number of years (duration)
Example:
Suppose we deposit ₦1,000,000 in a bank account offering 3% interest, compounded monthly with 5 years duration. How will our money grow? Let’s use the above formula to calculate our interest;
Investment – ₦1,000,000
Interest – 3% per annum
Tenure – 5 years
Compounded – quarterly, therefore, the compounding periods are 4
= ₦1,000,000 (1.16118)
= ₦1,161,184.14
The compound interest in this case is ₦1,161,184.14. The interest at the end of the investment tenure is ₦161,184.14. Hence, with higher compounding periods, the interest will also be higher.
Conclusion
According to Albert Einstein, he referred to compounding as the 8th wonder of the world. With compounding, you can make your money work harder for you. The interest that accumulates earns more interest in the long-term. Also, the longer you stay invested, the higher will be the return from an investment. Hence, it is advisable to start investing early to benefit from the power of compounding.
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