You may have heard the terms "simple" and "compound" interest "n" times in school. You may have solved various problems on these concepts as well. But it was not until you started your career that you realised how important they are for our personal finances. It is these rates that decide how much your investment will yield at the time of maturity or how much you will pay on
interest for availing a loan. Knowing these calculations will help you make smart financial decisions.
Read on to learn more about simple interest and compound interest.
What is simple interest?
Simple interest represents the cost of borrowing. It is the interest levied solely on the principal amount. Simple interest is ideal for loan products because as a borrower, you only need to pay interest on the actual sum borrowed from your lender for a specific period.
Simple interest is used in
consumer loans and vehicle loans. However, instead of using simple rates, that is also sometimes known as flat rates, in the context of loan products, lenders use reducing rates. Under this rate, the interest is calculated on the outstanding debt rather than the original loan amount.
Fixed deposits and bonds are two examples of investment products that use the simple interest concept.
How does simple interest work?
Simple interest is easy to calculate. You need to multiply the applicable interest rate by the duration and principal amount. Here is the formula.
Simple Interest = (Principal × Rate × Tenure)
Note: The tenure can be in days, months, or years. You must adjust the rate accordingly. Let us take two illustrations to get the concept better.
Scenario 1
Assume you put Rs 1,00,000 in a bond with a maturity period of 20 years and a coupon rate (interest rate) of 10%. In this case, the bond issuer will pay you Rs 10,000 every year for the next twenty years, and your total interest income will be Rs 200,000 at maturity.
Simple Interest = (Rs 1,00,000 × 10% × 20)
= Rs 2,00,000
Scenario 2
Suppose you took out a
used car loan for Rs 50,000 for a year, and the lender charged you 8% interest based on your profile.
In this case, your monthly interest payment will be around Rs 333, with a total interest payment of around Rs 4,000 at the end of the loan term.
Simple interest: (Rs 50,000 × 8% × 1)
= Rs 4,000
Also Read: Getting The Best Interest Rate On A Used Car Loan-Everything You Need To Know What is the compound interest rate?
Compound interest is charged on both the principal and any gains made on it. It is the interest levied on the interest earned throughout your investment. Compound interest has the potential to grow your wealth exponentially.
Compounding can be done on a daily, weekly, monthly, semi-annual, or annual basis. The more the frequency of compounding, the greater the accrual of interest and the faster your income grows.
Compound interest is rarely used on loan products because it makes repayment impossible, especially if the loan is substantial, such as a
mortgage loan.
How does compound interest work?
You can calculate this interest rate using the following formula–
Compound Interest = P(1+r/n)^(n*t)-1)
Here,
"P" represents a principal investment
"r" refers to the rate of interest
"t" refers to tenure, and
"n" refers to the compounding frequency
Let us take an illustration to understand its applicability.
Assume you put Rs 10,000 into any scheme for a period of five years. Your investment provides a 10% interest rate with the added benefit of compounding. Your total interest earnings, in this case, will be Rs 6,105. Here is how
Compound Interest = Rs (10000 × ((1+10%) ^ (5) -1)
= Rs 6,105
When comparing the returns on the same investment at simple interest while holding all variables constant, your interest earnings will be Rs 5,000, which is Rs 1,105 less than what you would have earned through compounding.
Compound vs Simple Interest Know the difference
You have already learned about compound interest and simple interest differences through an example. Let's take a quick look at the other parameters that differentiate them.
| Parameters | Simple Interest | Compound Interest |
|---|
| Formula | (P×r×t) | {P(1+r/n) ^ (n*t)} |
| Applicability | Interest is levied on the principal borrowing/investment. | Interest is levied on the principal investment plus interest income. |
| Growth | Investments with simple interest returns grow slowly. | Exponential wealth growth |
| Returns | Lower returns | Higher returns |
| Principal | Your principal investment remains constant over the years. | The principal amount grows each year as interest earnings are added to the investment. |
| Suitability | They are ideal for loan products or short-term investments. | They are best for investments. |
Also Read: Simple Steps to Effectively Manage a Debt Repayment Conclude
Simple and compound interests are totally different from one another. Where the former is appropriate when borrowing funds from a lender, the latter should always be preferred when making any investment. The power of compounding is a well-known phrase in the investment world. By careful selection of your investment, putting a few thousand rupees in a scheme like mutual funds or recurring deposits from the initial years of your career can make your capital grow exponentially.
