What is the difference between compound and simple interest?

When it comes to the amount of interest on a loan, the loan agreement should spell out whether the interest is simple or compound.

Simple Interest

Agreements that use a simple interest formula multiply the interest rate by the principal amount of the loan to calculate the fixed amount of interest to be paid along with the principal amount borrowed. Simple interest is only calculated on the principal amount of the loan.

For example, a $10,000 loan with a 7% simple interest rate would require the borrower to pay $700 in interest ($10,000 x .07 = $700). If the loan is going to be repaid over a period of three years, you will need to multiply the amount of simple interest by three, giving you a total of $2,100 in interest to pay.

In summary, the borrower would be getting $10,000 up front and would have to agree to repay a total of $12,100 over the three years ($10,000 + $2,100).

Compound Interest

With a compound interest calculation, the compound interest accrues on the amount of the unpaid loan principal and accumulated interest from previous periods. So, when a borrower agrees to compound interest, they are in effect paying interest on the interest.

Where the amount of interest on a simple interest loan is the same from year to year, the amount of interest paid on a compound interest loan will vary from time period to time period.

Generally speaking, the borrower will pay more over the life of the loan to borrow money under a compound interest loan than they would for a simple interest loan.

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