What are advantages of compound interest versus simple interest?

Answer 1

This question applies usually to investment of money in banks, so I shall answer it in this context:

If you invest £10,000 in a bank that offers you 5% simple interest per year, you will earn £500 per year, so after 5 years, you will have £12,500.

If you invest that same £10,000 in a bank that offers 5% compound interest per year, you will earn the following amounts each year:

Year 1: 5% of £10,000 = £500

Year 2: 5% of £10,500 = £525

Year 3: 5% of £11,025 = £551.25

Year 4: 5% of £11,676.25 = £583.81

Year 5: 5% of £12,260.06 = £613.00

TOTAL = £12,873.06

Therefore you have earned £373.06 than you would otherwise, so compound interest earns you more money!

Also, compound interest is much easier to calclulate for the banks, as they can calculate the interest from how much you have in your account at the beginning of the year, rather than having to figure out what your starting figure was.