Question

How does simple interest compare to compound interest? Which is more desirable to an investor? Why? How does the frequency of compounding affect returns?

Answer 1

Simple Interest : simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent.simple interest is the sum paid for using the borowed money, for a fixed period

Formula : Simple Interest = Principal amount (P) x Interest Rate (I) x Term of loan or deposit (N) in years.

Compound Interest : Compound Interest calculated by multiplying the principal amount by the annual interest rate raised to the number of compound periods, and then minus the reduction in the principal for that year whenever the interest becomes due for payment, it is added to the principal, on which interest for the succeeding period is reckoned, this is known as compound interest

Formula : Compound Interest = Total amount of Principal and Interest in future less Principal amount at present

Which is more desirable to an investor : Simple interest is calculated on the principal amount of a loan only. Compound interest is calculated on the principal amount and also on any accumulated interestof previous periods that was not paid, and can thus be regarded as “interest oninterest.If a loan is paid timely and there is no accumulated interest both a simple interest loan and a compound interest loan will be exactly the same.

Frequency of compounding affect returns : you will see the effect of compounding only if the interest is not paid out (in case of cumulative fixed deposits). If the interest is paid out regularly, there is no compounding and the effect will go down (unless you reinvest the proceeds).Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interesy.