WHY COMPOUND INTEREST IS MORE BENEFICIAL TO INVESTORS THAN SIMPLE INTEREST

People are not well-equipped to make judgments relating to financial management if they do not comprehend fundamental financial principles. Financially literate people are capable of making wise decisions on borrowing, investing, and other financial decisions. (Leora Klapper, Annamaria Lusardi and Peter van Oudheusden, 2015).?

The cost of borrowing money, such as the money added to loan debt, is known as interest. Simple interest and compound interest are the two methods for calculating interest. Mathematically, Simple interest is the product of the daily interest rate, the principal, and the number of days between payments. i.e Simple?Interest = P × I × N, where: P =Principal, I=Interest?rate (in percentage), and N=Term?of?the?loan. Simple interest is calculated on a loan's principal, or initial sum (Adams Hayes, 2021).

Contrarily, compound interest is calculated based on both the principal amount and the interest that is accrued on it each period. Mathematically, Compound interest is calculated using the formular: Compound?Interest = P((1+i)n ?1) where P=Principal, I = rate?in?percentage?terms, n= Number?of?compounding?periods?for?a?year. For example: Let's say you deposited money in the bank for two years, and the bank offered to increase your account balance by 15% per year. Will the bank deposit a more significant sum into your account the next year than it did the previous year, or will it deposit the same sum each year?, the bank will definitely deposit a more significant sum into your account the next year than it did the previous year because your account balance had increased the first year (accrued principal and interest) already and the interest for the second year will now be based on the current account balance (principal) unlike simple interest.

Any financially inclined investor will choose compound interest over simple interest for profit’s sake. Compound interest returns more profit compared to simple interest.

CITATIONS

Klapper, L., Lusardi, A. and Van Oudheusden, P., 2015. Financial literacy around the world. World Bank. Washington DC: World Bank.

Adams Hayes. (2021) Personal Finance [Online]. Available at: https://www.investopedia.com/terms/s/simple_interest.asp (Accessed: October 30, 2021)