What is the primary difference between simple and compound interest?

What is the primary difference between simple and compound interest?

• A. Simple interest involves taxes; compound interest does not
• B. Simple interest is based solely on the principal; compound interest includes accrued interest
• C. Simple interest is often used for short-term loans; compound interest is for long-term
• D. Simple interest is easier to calculate than compound interest

Answer: (B)

The primary difference between simple and compound interest lies in how each type calculates interest over time. Simple interest is calculated only on the principal amount, which means it is a fixed percentage applied to the original sum of money throughout the duration of the loan or investment. This method results in the same interest earned or paid each period, making it straightforward to compute. In contrast, compound interest takes into account not only the principal but also the interest that has already been added to it. Each period, interest is calculated on the new total amount (the principal plus any interest that has accrued), which can lead to interest being accumulated on previously earned interest. This compounding effect can significantly increase the total amount of interest earned or paid over time compared to simple interest, especially over longer periods. This understanding illustrates why the other options do not accurately capture the core distinction between simple and compound interest. The focus on principal alone in simple interest versus the inclusion of accrued interest in compound interest is what fundamentally sets them apart.

The primary difference between simple and compound interest lies in how each type calculates interest over time. Simple interest is calculated only on the principal amount, which means it is a fixed percentage applied to the original sum of money throughout the duration of the loan or investment. This method results in the same interest earned or paid each period, making it straightforward to compute.

In contrast, compound interest takes into account not only the principal but also the interest that has already been added to it. Each period, interest is calculated on the new total amount (the principal plus any interest that has accrued), which can lead to interest being accumulated on previously earned interest. This compounding effect can significantly increase the total amount of interest earned or paid over time compared to simple interest, especially over longer periods.

This understanding illustrates why the other options do not accurately capture the core distinction between simple and compound interest. The focus on principal alone in simple interest versus the inclusion of accrued interest in compound interest is what fundamentally sets them apart.