Question: Compound vs. Simple Interest
Use the passage below to answer the following question.
When investing money, it is important to know that interest can be
calculated in two ways. Those ways are referred to as simple interest
and compound interest.
Simple Interest
Simple interest is easier to determine than compound interest.
Simple interest is calculated only on the principal, or original
amount, placed into the investment. Simple interest is calculated
annually using the principal balance and excluding any interest that
has accrued during the year.
Simple Interest = $\frac{P \times R \times T}{100}$
$P$ is the Principal amount (the initial amount borrowed or invested)
$R$ is the Rate of Interest (in percentage)
$T$ is the Time (in years)
Compound Interest
Unlike simple interest, compound interest is calculated on the
principal amount AND on the accumulated interest. Look at it as
making interest on the interest you have previously earned. The
If you are looking for interest making money on itself, you would choose
which of the following?
simple interest
no interest
compound interest
1. **State the problem:**
You want to know which type of interest makes money on itself: simple interest, no interest, or compound interest.
2. **Recall the definitions:**
- Simple interest is calculated only on the principal amount $P$ using the formula:
$$\text{Simple Interest} = \frac{P \times R \times T}{100}$$
- Compound interest is calculated on the principal plus the accumulated interest, meaning interest earns interest.
3. **Key concept:**
Compound interest means you earn interest on the interest already earned, so your money grows faster.
4. **Answer:**
If you want interest that makes money on itself, you choose **compound interest**.
This is because compound interest reinvests the earned interest, increasing the total amount that earns interest over time.
**Final answer:** compound interest