# Simple vs. Compounding Interest: Definitions and Formulas

Jan 2, 2023

Interest is the cost of borrowing money or the reward for lending it. There are two types of interest: simple interest and compounding interest.

Simple interest is a type of interest that is calculated only on the principal amount of the loan or deposit. It is typically expressed as a percentage of the principal and is paid or earned at a fixed rate over a specific period of time.

The formula for calculating simple interest is:

Simple Interest = Principal x Interest Rate x Time

For example, if you deposit \$1000 at a simple interest rate of 5% per year for 2 years, the total interest earned would be \$100 (\$1000 x 5% x 2 years).

Compound interest is a type of interest that is calculated on both the principal amount of the loan or deposit and the accumulated interest from previous periods. It is typically expressed as a percentage of the principal and is paid or earned at a fixed rate over a specific period of time.

The formula for calculating compound interest is:

Compound Interest = Principal x (1 + Interest Rate)^Time

For example, if you deposit \$1000 at a compound interest rate of 5% per year for 2 years, the total interest earned would be \$110.25 (\$1000 x (1 + 5%)^2 years).

By understanding the difference between simple and compounding interest and the formulas for calculating them, individuals and businesses can make informed decisions about borrowing and lending money. It’s always a good idea to carefully research the terms and conditions of a loan or deposit, including the interest rate and frequency of compounding, before making any financial decisions.