Simple vs. Compound Interest: Computations and Misconceptions

Introduction

In both the math classroom and in personal finance, you’re likely to see two types of interest. Before we get to what they are, let me indicate that interest is a premium payed on some investment or loan over time. The amount of interest, and how frequently it is added, are two factors determined when the initial transaction is made. It is very common for this initial transaction to be in the form of a loan, maybe for a down payment on a house, or to pay tuition for education. Nonetheless, if there is interest on such a loan, it increases the amount of money that needs to be paid back over time. That’s where the similarities end between the two main types of interest: simple interest and compound interest.

If a transaction is made with simple interest, then the rate at which interest is added remains the same. One addition of interest to the total amount owed is sometimes called an installment; in that case, all installments are the same size.

On the other hand, if the transaction is made with compound interest, that means the installments of interest grow bigger over time. In practice, the increasing size of these installments can quickly become overwhelming if left unchecked.

The core of this article is about calculating simple and compound interest by analyzing and applying a few main formulas. From there I’ll continue to explore those formulas in some depth, detailing some other things that can be done with the…