# What's the difference between simple and compound Interest?

Modified on Thu, 27 Apr 2023 at 10:29 AM

It is important to understand the two types of interest when you are considering borrowing money. The two main types are Simple Interest and Compound Interest. Let’s get into the differences between them!

Firstly, the concept of interest is essentially the cost of borrowing money. It is usually a percentage you pay when someone loans you money.

Simple Interest

Simple interest is determined by multiplying the interest rate by the principal (total amount you are borrowing) by the number of days that elapse between payments.

Simple interest is generally paid over a certain period and is a fixed percentage of the total amount that was borrowed.

Let’s show this concept in an example. Let’s say a student gets a simple-interest loan to pay one year of college tuition, which costs \$18,000, and the annual interest rate on the loan is 6%. The student repays the loan over three years.

The amount of simple interest paid is:

\$18,000 × 0.06 × 3 = \$3,240

The total amount paid is:

\$18,000 (Principal) +\$3,240 (Interest) = \$21,240

Simple interest loans are a great option for borrowing money.

Compound Interest

Compound interest is the more complex type of interest. It is based on the principal (total amount you are borrowing) and the accumulated interest from previous periods.

Compound interest is mostly used for credit cards. Compound interest on credit cards adds to your debt when you carry over a balance from month to month. When you carry over a balance on your credit card, you are being charged interest on that amount, plus interest on the total interest owed the month before.

Daily compounding means that the credit card company calculates the interest you owe daily and adds that to the card's balance.

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