Simple Interest vs Compound Interest – Same or Different?
Do you understand the difference between simple interest and compound interest? Other than the term itself that is different from each other, both simple interest and compound interest have different calculation method. Try remembering the mathematics subject that you have ever learnt during your school times. You definitely ever learnt about how to calculate simple interest and compound interest. However, if you can’t recall, don’t worry as you are currently on the right article to recall about these two types of interests.
You Won’t Understand if You Don’t Know
First of all, before we discuss about the calculation method of both of these interest types, you need to understand what these interest types are all about. Simple definition will give you clearer image and help you understand the calculation method that will be described later on in this article.
The simple definition of simple interest and compound interest is as follows:
Simple interest is the interest that is calculated based on the principal only.
Compound interest is the interest that is calculated based on the principal and interest obtained in the previous period.
So, have you had a clearer idea about the difference between simple and compound interest? Or is it still blurry? Don’t worry! After learning about the calculation method, you will be able to clearly tell the difference between these two.
Calculation Method Difference
As the definition of both simple and compound interest are different, the way of calculating both these interests are different as well. We will be using sample scenario to help understand the difference more easily.
Scenario: You invest your money with amount of Rp 100 million with interest of 10% per annum for period of 5 years.
We will start with simple interest calculation. Simple interest only calculates the interest from the principal amount only. From this sample scenario, based on simple interest calculation you will be getting interest of amount Rp 10 million every year as simple interest only calculates interest from the principal amount only that is Rp 100 million. Hence, you will get total return of Rp 150 million that consists of Rp 100 million principal or initial investment and total interest of Rp 50 million by the end of year 5.
However, this is not the case for compound interest calculation. What is the difference? Based on the above-mentioned definition, compound interest calculates interest based on principal amount and the interest that is previously obtained. So, this is the main difference of simple and compound interest. With compound interest calculation method, the interest that is obtained will be different every year. For example, using the same scenario, the interest that will be obtained at the end of year 1 will be Rp 10 million. As such, the interest obtained at the end of year 2 will be calculated by multiplying 10% interest with the principal of Rp 100 million and Rp 10 million that is obtained in the previous year that is amounted to Rp 110 million. Hence, the interest that is earned at the end of year 2 is Rp 11 million and it goes the same way for the rest of the year. With compound interest methodology, by the end of 5 years period the total return you will get is Rp 161,051,000 that consist of principal or initial investment of Rp 100 million and total interest of Rp 61.051 million.
In simple, compound interest will give you higher return for longer horizon, especially if you invest regularly. Try imagining if you invest regularly, for example investing with initial amount of Rp 10 million and regularly top up Rp 1 million per month for period of 10 years with assumption of 10%* return per annum. Could you guess the total return that you will earn at the end of year 10? The answer is you will get total return of approximately Rp 230 million at the end of year 10! Isn’t it amazing? And of course you will be able to earn higher at the end of your investment period if you invest with higher amount.
So, what else are you waiting for? Let’s invest!
*Interest example is for illustration only