Final answer:
Simple interest is calculated only on the initial principal amount, while compound interest is calculated on the principal and the accumulated interest from previous periods. Compound interest can lead to significant growth over time, particularly with larger amounts and longer investment periods.
Step-by-step explanation:
Difference Between Simple Interest and Compound Interest
Simple interest and compound interest are two fundamental concepts in finance, relating to how interest is calculated on money that is borrowed or invested over time.
Simple Interest
Simple interest is calculated only on the original principal amount, or the initial amount of money that was borrowed or invested. It does not take into account any interest previously earned. The formula for simple interest is I = PRT, where 'I' is the interest, 'P' is the principal amount, 'R' is the rate of interest per period, and 'T' is the time the money is invested or borrowed for.
Compound Interest
In contrast, compound interest is calculated on the principal amount and also on the accumulated interest of previous periods. This means that the interest in the next period is earned on the total accumulated amount (principal + interest), which leads to a more substantial growth over time, especially with larger sums of money or longer periods of investment. After three years, for example, an investment of $100 at a certain interest rate could amount to a total of $115.76 with compound interest, which is $0.76 more than what would have been earned through simple interest.
The effect of compound interest becomes more pronounced over longer periods and with larger sums of money, making it a powerful factor in the growth of investments.