What is the difference between compound interest and simple interest? The answer is the difference between the sky and and sea. Let me illustrate this. Would you be excited if your good friend comes along one day and say, “I can double your money in 6 years”. Does that sound like a good offer? 100% return, my friend!
If you knew the difference between simple interest and compound interest, then you might not be all that excited. Based on simple rate of return, the doubling of your money or 100% increase in 6 years, is only about 12% compounded per year!! A huge difference between 100% and 12% and not all that spectacular, isn’t it? Granted that 12% is still quite good but it is a far cry of 100%.
The example below will illustrate this. Say you invest 10,000 and double the money in 6 years means $ 20,000.
Simple interest = ( 20,000 – 10,000 ) / 10,000 x 100
= 100%
Compound interest calculated step by step is as follows:
Year 1. 10,000 x 12% = $11,200
Year 2. 11,200 x 12% = $12,544
Year 3. 12,544 x 12% = $14,049
Year 4. 14,049 x 12% = $15,735
Year 5. 15,725 x 12% = $17,623
Year 6. 17, 623 x 12% = $19,738 or approximately 20,000
For a quick way to estimate compounding interest, you can use the Rule of 72.
From the concept of compounding interest above, the concept called time value of money is developed. And all the calculation steps can be expressed in a simple equation as here.