What is simple and compound interest in 5 steps

Usman Sheikh

Step 1: Definition of Interest Interest is the cost of borrowing or the reward for lending money. It is usually calculated as a percentage of the amount borrowed or lent.

Step 2: Simple Interest Simple interest is the interest calculated only on the principal amount borrowed or lent. It does not take into account any interest earned on previously accumulated interest. The formula for simple interest is:

Simple Interest = Principal x Interest Rate x Time where the interest rate is given as a percentage per year, and time is the duration of the loan or investment in years.

Step 3: Example of Simple Interest Suppose you borrow $10,000 at a simple interest rate of 5% per year for 3 years. The interest you will pay is:

Simple Interest = $10,000 x 5% x 3 = $1,500 So you will pay back a total of $11,500 ($10,000 principal + $1,500 interest) at the end of the 3-year term.

Step 4: Compound Interest Compound interest is the interest calculated on the principal amount as well as any interest earned on previously accumulated interest. It is often used in savings and investment accounts. The formula for compound interest is:

Compound Interest = Principal x (1 + Interest Rate)^Time - Principal Step 5: Example of Compound Interest Suppose you invest $10,000 at a compound interest rate of 5% per year for 3 years. The interest you will earn is:

Compound Interest = $10,000 x (1 + 5%)^3 - $10,000 = $1,576.25 So you will have a total of $11,576.25 ($10,000 principal + $1,576.25 interest) at the end of the 3-year term. Notice that the interest earned in the second and third years is based on the principal amount plus the interest earned in the previous year.