SIMPLE INTEREST

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.