Compound Interest Vs. Simple Interest: Know the Difference & How to Calculate
Interest is based on how much money was invested or borrowed. You can figure out how much interest you owe in two ways. There are two kinds of interest: simple interest (SI) and compound interest (CI). Simple interest is only interested in how much a loan or investment costs. The principal sum is used to figure it out. Compound interest is the interest that is added to the already paid interest. It’s worked out based on the interest and principal from the last period. The difference between SI and CI is talked about in detail.
What is Simple Interest?
When you borrow money, the only cost is interest. Borrowers would profit from simple interest because they would only have to pay interest on loans they take out. Simply put, simple interest is the amount given to the person who borrowed the money to use it for a certain amount of time.
It’s easy to figure out. To figure out simple interest, multiply the principal amount, the period, and the interest rate. Simple interest doesn’t take any interest that has already been earned. Only the amount of the first payment is taken into account.
The interest a person or a car loan owes is determined by simple interest. Simple interest is used to determine the return on investment for only a certificate of deposit.
What is the Simple Interest Formula?
To figure out simple interest, you add the principal amount, the length of time, and the interest rate for the period. The time unit could be a day, a month, or a year. Since this is the case, you need to change the interest rate before multiplying it by the principal amount and the time.
The following formula could be used to figure out the simple interest:
PIN = Simple Interest
Where P is the main amount
I – Periodic Interest Rate
N– Tenure
Example 1: The principal amount of a loan is 50,000 INR, the loan term is 60 days, and the interest rate is 5% per year. In this case, you could find the simple interest by doing the steps below.
The principal is INR 50,000, and the loan is due in 60 days.
Interest rate: 5% a year, or 0.014% a day.
INR 410.95 = simple interest
So, someone who took out a 50,000 INR loan for 60 days would pay a total of 410.95 INR in interest.
What is Compound Interest?
In contrast to simple interest (SI), compound interest (CI) adds interest to both the principal and any interest that has already been added. The amount of interest adds to the amount owed. CI stands for “Interest on Interest.” The goal is to make as much money as possible by adding interest to the original amount.
The bank, financial institution, or lender sets the rate at which interest is added to a loan. It could happen every day, once a week, twice a week, once every three months, or even once a year. If compounding happened more often, the interest earned would go up. Because of this, compound interest helps investors more than it helps people who borrow money.
Some loans from banks have interest that adds up. Most of the time, though, investors use compound interest. Compound interest is also used in fixed deposits, mutual funds, and other investments that let earnings be re-invested.
What’s the compound interest calculation formula?
When figuring out CI, the principal amount, the interest, and the no.of compounding periods are all multiplied by one. Then, to get the CI, you must take the primary amount away.
You can use the formula below.
A=P(1+r/n)(n*t)-1), where A is compound interest
P is the principal amount, r is the interest rate, and n is the number of times the interest is added.
t is the no.of years (duration)
Example 1
Let’s use an example to show you how to figure out CI. At a 10% interest rate for 5 years, Mr Charan puts away 10,000 INR. You can figure out the CI by using the formula.
A = 10000*((1+10%)^(5)-1)
A = INR 6,105.
Interest for INR 6,105 has been paid to Mr Charan. When he is done investing, he will have INR 16,105. (The amount borrowed plus the interest on it). On the other hand, the simple interest for the same over the same period is INR 5,000. The difference between SI and CI is 1,105 INR.
What’s the Power of Compounding?
Adding interest is the process of compounding. It means that both the initial investment and the profits grow steadily when they are returned to the business. Because of this, investments grow faster. As compounding happens more often, the value of an investment will go up. The no.of times interest is added up in 1 year is called the compounding frequency.
Compounding is an interesting idea, so it’s easy to see why Albert Einstein called it the “eighth wonder of the world.” By letting your money grow, you can make it work even more. As interest builds up over time, it grows. Also, the more you play, the more you will get back from your investment. To get the most out of compounding, you should start spending money when you are young.
Conclusion
We already know from the SI vs CI definitions that interest is usually shown as a percentage so it can be either Simple Interest or Compound Interest. The principal of a loan or deposit is used to figure out simple interest. On the other hand, compound interest is worked out by starting with the principal amount and adding interest to it each period. This was talked about when SI and CI were put side by side. You know everything you need to know to figure out both simple and compound interest. If you want to learn more, you should go to Piramal finance.