Simple Interest and Compound Interest

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Simple Interest

Simple interest is calculated by multiplying the loan amount (e.g. $1000) by the interest rate (e.g. 5%) by the number of payment periods over the life of the loan (e.g. 24 months). The thing to keep in mind here is that the interest rate may be expressed in terms of an annual rate, e.g. 5% per annum, whereas the payment periods might be expressed in months, e.g. 24 months. To ensure your calculation of simple interest is accurate, you need to ensure that both the interest rate and the payment periods are expressed in the same manner, say annually or monthly. For example, using the figures above, our $1000 loan would be at 5% per annum, and taken out over just 2 years (as opposed to 24 months). So here the calculation would be 1000 x 0.05 x 2 (loan x interest x term) = 100. So, the amount of simple interest that we would pay on this loan over the two year term would be $100. Interest rates are seldom calculated using the simple interest rate formula however, and are more likely to be calculated using the compound interest formula.

Compound Interest

Compound interest relates to charges the borrower must pay not just on the principal amount borrowed, as in simple interest, but also on any interest outstanding at that point in time. To illustrate the difference between compounding interest and simple interest, consider the following very simplified scenario of a $1000 loan taken out at 10% over 2 years (assuming no payments are made until the end of the loan):

Example of Simple vs Compound Interest

First year: $1,000 x 1 year x 10% = $100 in interest
Second year: $1,000 x 1 year x 10% = $100 in interest
Total Interest: $200
Total of the principal amount plus interest = $1,200

In this scenario, the total amount of interest paid over the life of the loan would be $200


Compound Interest:

First year: $1,000 x 1 year x 10% = $100 in interest
Second year: $1,100 x 1 year x 10% = $110 in interest
Total Interest: $210
Total of the principal amount plus interest = $1,210

In this scenario, with interest compounded annually, the total amount of interest paid is $210

Now keep in mind that this is a somewhat simplified example, but it should be enough to highlight the workings of compound interest. In reality you’ll be expected to make payments on your loan at regular intervals for the life of the loan, and therefore the effects of paying interest on your interest will be different from the above example. For the most part however, any loans you take out will, or should, have regular fixed payments. At the beginning, these payments will go primarily to paying off the interest on the loan, with a smaller percentage going to paying off the principal. Over time, this ratio changes to more of the principal being paid off with each installment.