Answer: The key difference between simple interest and compound interest is the way interest is calculated and added to the principal amount.
Simple interest is calculated on the principal amount only. It is a fixed percentage of the principal that is added to the amount borrowed or invested each year. For example, if you borrow $1,000 at a 5% annual interest rate for 3 years, you will pay back a total of $1,150 ($1,000 + $50 interest per year x 3 years).
Compound interest, on the other hand, is calculated on both the principal and any accumulated interest. It means that interest earned in one period is added to the principal amount, and the interest is then calculated based on the new principal amount. This results in interest that is "compounded" over time, meaning that it can increase significantly over long periods.
For example, if you invest $1,000 at a 5% annual interest rate for 3 years, the first year's interest will be $50 (5% of $1,000). The second year's interest will be $52.50 (5% of $1,050, which is the original principal plus the first year's interest). The third year's interest will be $55.13 (5% of $1,102.50, which is the principal plus the interest from the first two years). At the end of the three years, you will have a total of $1,157.63 ($1,000 + $50 + $52.50 + $55.13).
The key effect of this difference is that compound interest can result in higher overall interest earnings over time compared to simple interest. This is especially true when the investment or loan is held for a long period, as the interest earned each year is added to the principal amount, resulting in higher interest earnings each subsequent year. However, compound interest can also result in higher debt for borrowers, as the interest owed is added to the principal amount, which can lead to more significant interest charges over time.
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