Interest can be an expense or a revenue. Interest expense is the cost of borrowed money. Interest income is the earnings on money that has been lent or invested. The sum against which interest is calculated is known as the principal. Interest on the principal may be calculated as simple interest or compound interest.

The primary difference between simple interest and compound interest is
the treatment of the length of time for which interest is paid or earned.
In simple interest calculations, the number of time periods is
disregarded. For example, $100 earning 10 percent simple interest results
in interest income of $10 per year regardless of how many years are
involved. That is, the amount of interest equals the
**
interest rate
**
times the principal. The accumulated interest and the number of time
periods do not enter into the calculation.

On the other hand, in compound interest calculations, each time period affects the amount of interest earned or paid. That is because the accumulated interest itself earns interest, or is said to be compounded. For example, $100 earning 10 percent compound interest results in interest income of $10 in the first year. In the second year, interest income increases to 10 percent of $110, or $11, because the first year's interest is added to the principal. In the third year the interest payment increases to $12.10, or 10 percent of $121.

Thus, it can be seen that using simple interest, a $100 investment would
earn $30 over three years at 10 percent. Using compound interest, the same
investment would result in interest income of $33.10. Compound interest is
widely used in
**
financial planning,
**
because it is assumed that interest on the principal would earn the same
interest rate as the principal does. Simple interest is useful in
situations where the interest payments are not being reinvested.

*
SEE ALSO
*
:
Interest Rates

*
[
*
*
David
*
*
P.
*
*
Bianco
*
*
]
*

## Comment about this article, ask questions, or add new information about this topic: