Just wondering how to know when to use either the simple interest formula or compound interest formula and whats the difference? Unsure when to use which in some questions.
I'm pretty sure they will state/hint when to use which. Please provide examples on where the confusion lies.
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The main difference between simple interest and compound interest is generally overlooked. The difference lies in how the compounding
actually happens.
In
simple interest, we have a principal amount \( P \), and we
only ever compound on top of it. This means that after one period, our interest calculated will be with respect to \( P\). After two periods, the amount will
still be calculated with respect to \(P\).
In
compound interest, we start with a principal amount \( P\), but
we only ever compound on top of that one ONCE. Instead, after we compound it once, we
then compound on the NEW amount. So whereas after one period we compound on top of \( P \), for the second period we compound on top of \( P \times \text{the interest factor} \) instead.
And well, the interest factor (a.k.a. compounding factor) is just a fancy name for \( 1+r \).