In finance, interest is an important part of most investing and borrowing decisions. Interest is, in many respects, a "lending fee": it is money that is charged or paid based on the total cumulative amount on loan, and it is typically calculated in one of two ways. Simple interest is interest calculated based on a flat percentage rate of the principal, and remains constant for the duration of the investment. Compound interest is also based on a percentage of the principle, but then is itself added to the principle, so that the principle — and the interest amount owed on it — grows with each new interest period. While simple interest and compound interest may seem similar on the surface, over time, they yield much different results.
The basic principle of simple interest is that the interest rate remains constant, and the payments owed are predictable and fixed. For example, if a person takes out a two-year personal loan of $100 U.S. Dollars (USD) based on a simple interest rate of 10% annually, his interest due will be $10 USD per year, for a total debt of $120 USD. The formula for calculating simple interest is I=PRT, where “I” is total interest; “P” is the principle; “R” is the interest rate, in decimal form; and “T” is total duration of the loan, in years.
Had the same loan been subject to a compounding interest rate, however, the total amount due would have been slightly more. Simple interest and compound interest rates both use the principle as the base of the calculation, but in a compound scenario, that principle grows with every interest payment. This means that after the first year, the principle in the example would no longer be $100 USD, but rather $110 USD. The 10% interest for the second year would be calculated on that amount, which would mean that the end amount owed would be $121 USD.
Compound interest is calculated with the formula S=P(1+R/N)^{NT}, where “S” is the future value of the investment; “P” is the original principle; “R” is the interest rate, in decimal form; “N” is the number of times per year that interest is compounded; and “T” is the total duration of the loan, in years. In compound interest scenarios, the rate of compound is very important. Some loans, like the one in the example, are compounded on an annual basis. Others use a monthly compound interest or even a daily compound interest scheme. Over time and with larger amounts of money, simple interest and compound interest can yield very different results.
Simple interest and compound interest can each be desirable in different circumstances, although compound interest, for better or worse, is the interest calculation most frequently used by banks and financial institutions. Compound interest typically favors the lender, as more money is owed at the end of the loan period. Most credit card companies extend credit on a continuous compounding scheme, where interest is calculated and owed on the total statement amount each month or year. This can make paying down the total amount more difficult, more costly, and more timely for many borrowers.
Credit card users generally do not have a choice when it comes to choosing between simple interest and compound interest. In many ways, compound interest is what makes extending credit possible for many credit card companies. Consumers may have more say when it comes to other investments and financial transactions, however. The choice is not always as direct as a selection between simple interest and compound interest, but banks and other lenders sometimes give borrowers some flexibility when it comes to negotiating the rates, frequency, and system of interest calculation. Different banks and institutions offer different, often competing interest rates, which makes doing one’s research pay off in many cases.