Simple (regular) interest, accrued interest, and compounding interest
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What are the Different Types of Interest?
The three types of interest include simple (regular) interest, accrued interest, and compounding interest. When money is borrowed, usually through the means of a loan, the borrower is required to pay the interest agreed upon by the two parties.
Simple (Regular) Interest
Simple or regular interest is the amount of interest due on the loan, based on the principal loan outstanding.
Example:
For example, if an individual borrows $2,000 with a 3% annual interest rate, the loan would require a $60 interest payment per year ($2,000 * 3% = $60).
Accrued Interest
Accrued interest is accumulated interest that is unpaid until the end of the period. If a loan requires monthly payments (at the end of each month), interest steadily accumulates throughout the month.
Example:
If $30 is the interest expense each month, the loan is accruing $1 of interest each day that requires payment once the end of the month is reached. In this example, by day 15, the loan will have accumulated $15 in accrued interest (but require payment once $30 is reached).
To learn more about how accrued expenses are recorded in accounting, click here.
Key Difference (Simple Interest vs. Accrued Interest):
The difference between these two types of interest are that regular interest is paid periodically (determined by the loan agreement), and accrued interest continues to be owed to the lender over time.
Compound Interest
Compounding interest essentially means “interest on interest.” The interest payments change each period instead of staying fixed. Simple interest is based solely on the principal outstanding, whereas compound interest uses the principal and the previously earned interest.
Example:
If a person borrowed $1,000 with 2% interest and has $100 of accrued interest, then that year’s interest would be $22. It is because the interest is paid on the principal ($1000) and the accrued interest ($100), for a total of $1100. 2% of $1100 is $22.
Key Difference (Simple Interest vs. Compound Interest)
If you put $5,000 in a bank account that earns 4% interest a year, you will have $5,200 by the end of the year. Now, if you keep the $5,200 in the bank for another year, you will have $5,408.
Simple
Simple interest would be the equivalent of receiving $5,200 after the first year, withdrawing the $200, and then having $5,000 before the next period. Every period the individual will receive $200.
Compounding
Compounding interest would increase the interest payments since you are receiving interest on your interest. If the individual left the $5,200 in their bank account, they would have $5,408 by the end of the next period (which is a $208 gain instead of the $200 with simple interest). This shows the power of compounding interest.
To learn more about simple vs. compound interest, click here.
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