Understanding Interest Types: Simple, Accrued, and Compounding Explained

Types of Interest: Simple, Accrued, and Compounding

The three primary categories of interest are simple regular interest, accrued interest, and compounding interest. When funds are borrowed through loans or credit agreements, the borrower is typically obligated to pay back the agreed-interest amount.

Simple or Regular Interest

Simple or regular interest refers to the total interest due on a loan based solely on the original principal amount.

Example:

If an individual borrows $2,000 with an annual interest rate of 3, they would be required to pay $60 in interest annually $2,000 * 3 = $60.

Accrued Interest

Accrued interest is the accumulated interest that accumulates over time and has not yet been pd. When monthly payments are due typically at month's , interest accrues consistently throughout each period.

Example:

If a loan requires a monthly payment of $30 as interest expense, accrued interest continues to accumulate at a rate of $1 per day until the final payment is made at the of the month. For instance, by day 15, the loan would have accumulated $15 in interest with the requirement for full payment once $30 is reached.

Key Difference between Simple and Accrued Interest:

The primary difference lies in when the payments are made; simple interest payments occur at predetermined intervals based on the loan agreement terms, whereas accrued interest accumulates until the of the specified period before being pd.

Compounding Interest

In contrast to regular interest, compounding interest involves interest on interest. The interest amount changes each period instead of remning constant. Simple interest is calculated solely based on the principal outstanding; however, compound interest includes both the principal and previously earned interest in its calculation.

Example:

When a person borrows $1,000 at an annual interest rate of 2 with $100 as accrued interest added to the principal, their total yearly payment would be $22. This is because interest accrues on the sum $1,000 + $100 = $1,100, leading to a calculation of $1,100 * 2 = $22.

Key Difference between Simple and Compound Interest:

If you deposit $5,000 into a bank account that earns an annual interest rate of 4, by the of the year, your balance would be $5,200. However, if you let this amount accumulate for another year without withdrawing any funds, your final total would grow to $5,408.

Simple Interest

With simple interest, you would earn $5,200 after one year and then withdraw the $200 in interest earned. This process repeats annually at a fixed rate $200 every period.

Compounding Interest

In comparison, compound interest increases over time because the interest is pd on both the principal amount and any previously earned interest. If you left your initial deposit of $5,200 in the bank for another year without withdrawing anything, it would grow to $5,408 by the of the following period - which represents a higher gn $208 than the fixed annual increase with simple interest $200. This demonstrates the power and advantages of compound interest.

For further reading on simple vs. compound interest, refer here.

Additional Resources

CFI offers courses that cover finance fundamentals and accounting principles to help you advance your career. Here are some additional resources:

Free Fundamentals of Credit Course

Types of Credit

Compound Interest Formula

Interest Rate Risk

See all commercial ling resources

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