Comparison of Simple Interest vs. Compound Interest

Comparison of Simple Interest vs. Compound Interest Student Name: Student Roll No: Course Code: Teacher Name: Concept of InterestWhen the money is borrowed by a person from a money lender or any bank/financial institution, some extra amount is charged by the lender which is the interest for the money lend. In simple terms, the interest is the cost charged by the lender to lend money to the borrower. This interest rate is decided mutually between the two parties, usually the lender having the deciding power (Calderone et al, 2018). Over a period, the interest can be calculated either daily, weekly, monthly, quarterly, half-yearly, semi-annually, and annually. The choice of the period is dependent on the lender's policy, with the semi-annual being the most preferred period for banking institutions (Bucher‐Koenen et al, 2017). Whether one is a borrower or a lender, a party needs to understand the concept of how the calculation of interest is made: There are two different forms of interest- simple interest and compound interest. The interest rate calculations impact the payment of the total amount. Thus, it is important to understand both kinds of interest to get clarity on how they are going to impact the repayments of the borrowed amount (Lusardi & Tufano, 2015). The interest rate method choice is dependent on several factors including the time value of money, opportunity cost, inflation, and associated risk. The calculation of simple interest is easy, whereas the calculation of compound interest is a bit complicated. If the computation of both is made for a given principal, at a given time and rate, it is universally observed that compound interest is always higher than the simple interest because of the effect of compounding on it (Lutz, 2017). Simple InterestOne of the most significant and basic concepts for mastering one's finances is knowing the concept of simple interest. With an understanding of how the interest works, better financial decisions can be made which helps in saving money. The calculating of the simple interest is considered to be easy: A car loan can be considered as a common example of simple interest. The formula used for the amount of interest calculation is S= P*i*n where P= Principal amount, i = rate of interest and n = number of years (Garg & Singh, 2018). Assume that a person deposited $10000 into an account where he will earn a simple interest of 5% per year. On an annual basis, the bank will pay 5% of $10000 that is $500 to the person, so $500 will be added to the account. This means that the total account balance will be $10500 at the end of the first year. Assuming the person does not withdraw any money, the interest received by the person on the principal amount of $10000, will be $500, which will make the total balance in the account at $11000 after two years (Khan & Jain, 2018). Compound Interest Compound interest can be defined as the interest which is calculated on the revised principal as a percentage, which is the original principal plus prior period accumulated interests. The interest of the previous period is added to the initial principal, thereby increasing the principal amount for the next period on which the interest is earned (Garg & Singh, 2018). In continuation with the above example, the compound interest calculated for the first period will be $500, (which is same as that in simple interest). Now, this interest will be added to the original principal, therefore the principle for the second period will $10500. The interest for the second period will be calculated on the new principal. At the end of the second year, an interest of $525 will be earned which is $25 more than that earned in case of simple interest. The total amount in the account at the end of the second year will be $11025 in comparison to $11025 in case of simple interest (Khan & Jain, 2018). Thus, based on the above discussion it can be inferred that simple interest is an interest that is calculated as a percentage of the principal amount whereas compound interest is an interest that is computed based on principal and accrued interest. The return on the simple interest is less as compared to that of the compound interest. Also, the principal on simple interest is constant whereas the principal on compound interest ...