What are Compound Interest and Simple Interest, and How to calculate it?
We’ve all heard of compound interest and simple interest somewhere. Starting from school, everyone is taught about simple and compound interest.
These two types of interests play a big role in an individual’s budgetary planning. So, let’s take a quick walk down memory lane and understand what exactly is simple and compound interest and how one can calculate them.
What is Simple Interest?
Simple interest refers to the rate of interest that is charged on a loan for a given period. In simple interest, the principal amount remains the same. For instance, the interest rate may be 10% on loan of ₹20,000 for 6 months.
Banks use simple interest to charge interest rates for loans. It is a quick and easy way of calculating the amount of interest that can be charged on a loan, i.e. the principal amount. It is usually applied for automobile loans or loans that are short-term. Some other loans may also use simple interest.
Importance of Simple Interest
Simple interest loans are helpful to the borrower in the following ways:
a. Easy to calculate
Simple interest is easy to calculate. It can be calculated only with the principal amount and the period for which it is taken, i.e. the loan tenure.
b. Less amount of interest
When taking a loan, it is best to get one on simple interest as the interest amount may be low.
This is because no interest is charged on the interest, which is not the case with compound interest.
c. No extra interest
Simple interest is calculated with the principal amount and tenure of the loan. But, compound interest includes interest on interest.
d. Good for loans
In a loan with simple interest, the interest amount can be less if the principal amount is paid earlier than it has to be paid.
How to Calculate Simple Interest?
Simple interest is calculated using the following formula:
Simple Interest = P × I × N
where,
P= Principal amount
I= Daily interest rate
N= Number of days between payments
Simple interest is usually paid or received at a fixed percentage over the principal amount for a specific period.
For example, assume an individual takes a simple interest loan on the principal amount of ₹18,000 for one year at a 6% annual rate of interest. The simple interest, in this case, will be as follows:
Simple Interest = P x I x N
= 18,000 x 0.06 x 3
= ₹3240
So, the total amount that needs to be paid by the individual would be:
Total= Principal amount + Simple interest
= 18,000 + 3240
= ₹21,240
What is Compound Interest?
Compound interest is defined as “interest paid on interest”. Compound interest is sometimes also referred to as compounding interest. It is the interest that comes with a loan or a particular deposit. The interest earned and the principal amount are both used to calculate compound interest.
Compound interest grows faster than simple interest. How fast this growth occurs depends on its frequency. In simpler words, the longer the period, the higher the compound interest.
Why is Compound Interest Important?
Compound interest is a quick and easy way to grow one’s wealth. The money that is invested is known as the principal amount. Compound Interest helps one earn returns on it. By the end of a specific period, one may have even doubled the previous amount invested. This is even more helpful for the youth that aims to grow their wealth in a small time. Reaching one’s goals becomes easier with compound interest.
When one opens an account that bears interest and saves up enough money, they enjoy compound interest. With the help of compound interest, people have security. They can face factors such as high prices that may affect a country’s wealth.
How to Calculate Compound Interest?
Compound Interest can be calculated using the following formula:
A = P (1 + [r / n]) ^ nt
where,
A = The amount of money after n years (this includes the interest)
P = The principal amount deposited or borrowed
r = The annual rate of interest (in decimals)
n = The number of times the interest is compounded per year
t = The number of years (time) the amount is deposited for
Let’s look at an example. Assume that a person deposits ₹5,000 in their savings account, which pays a 5% interest for 10 years.
So,
A = P (1 + [r / n]) ^ nt
A = 5,000 (1 + [.05 / 12]) ^ (12 * 10)
A = 5,000 (1.00417) ^ (120)
A = 5,000 (1.64767)
A = 8,238.35
So, in 10 years, the individual would have ₹8,238 in their savings accounts. This means that along with the deposit of ₹5000, the individual has received interest of ₹3,238.
Simple Interest vs Compound Interest
Simple and compound interests are beneficial depending on the individual’s choices. Simple interest makes use of only the principal amount. Compound interest also uses the interest tenure along with the principal amount.
Simple interest remains constant while compound interest grows over a while. So, it is beneficial for one’s loans and debts to be calculated with simple interest. But, investments and savings should be calculated using compound interest.
Final Thoughts
By the end of this article, the reader will have gained a deeper understanding of compound and simple interests. When investing, it is best to opt for compound interest on one’s account. But, it is best to have simple interest rates when taking a loan.
If used well, compound interest can help one generate wealth. In case of doubts, consult the financial experts at Piramal Finance. It will help you know their products and services, especially credit cards and personal loans.