Interest calculation has a significant part in any financial undertaking, be it lending or investment. In the case of loans, individuals are liable to repay that additional sum along with the principal amount. On the other hand, for investment, individuals earn an additional amount on their actual investment.
In this regard, there are two sub-types that everyone should be aware of, simple interest and compound interest. These are the two primary interest calculation methods, and it is vital to know the difference between them.
Difference between simple and compound interest
Here are some notable differences between compound and simple interest –
1. Calculation type
The method of calculation is one of the most prominent differences between these two interest computing systems. In simple words, simple interest is calculated against the principal amount for a predetermined tenor. Moreover, associated factors do not change in this calculation method. For instance, if an individual is taking out a personal loan, the interest will be calculated only on the principal amount.
On the other hand, compound interest has a different calculation method. Also known as the ‘interest on interest’ calculation method, the principal amount does not remain the same. The interest is calculated on the revised principal amount, which comprises the previous interest.
2. Formula and method of calculation
Here is an overview of how simple interest and compound interest calculations work in their respective formulas –
The formula of simple interest: S.I. = P × R × T; here, P stands for the principal amount, R stands for interest rate, and T stands for tenor.
Calculation: A loan of Rs.1.2 lakh was availed against a tenor of 3 years and an interest rate of 13%. So, the interest on this loan will be –
- SI = Rs. (1,20,000 X 0.13 X 3)
- SI = Rs.46,800
This Rs.46,800 will be the total payable interest on the loan amount for 3 years. Alternatively, one can take the assistance of online calculators to find personal loan EMIs, and other returns on investments.
The formula of compound interest: P (1 + r/n)^(nt); here, P is the principal amount, r is the interest rate and n is the number of times interest compounds, and t is tenor.
Calculation: Considering the same example as above, against a loan of Rs.1.2 lakh with a 13% interest rate and 3 years of the repayment period, the compound interest calculation will be –
- For the first year: The opening credit balance will be Rs.1.2 lakh, and interest payable will be Rs.15,600 (1,20,000 X 13%). Thus, the total closing balance of that year will be Rs.1,35,600.
- For the second year: Unlike simple interest, the calculation for the second year will begin with the closing balance of the previous year, i.e., Rs.1,35,600. Therefore, the interest payable for this year will be Rs.17,628 (1,35,600 X 13%). The closing balance for this year will be Rs.1,53,228.
- For the third year: The calculation here will remain the same as the 2nd year. Here interest will be calculated against the former year’s closing balance. For this year, the interest payable will be Rs.19,919 (1,53,228 X 13%). Thus, the closing balance for this year will be Rs. (1,53,228+19,919) = Rs.1,73,148.
Finally, to get the total interest payable over 3 years, one can add up the interest amount for these years. Therefore, it will be Rs. (15,600+17,628+19,919) = Rs.53,147.
Simple interest and compound interest both have applications in the interest calculation of investment and lending. However, owing to their difference in approach, they yield contrasting outcomes.
In terms of investments, compound interest will be preferred to generate a higher return than simple interest. For loans, simple interest is ideal as the interest repayment will remain flat and not compounded over time.
Putting these two interest calculation methods against each other can give a fair idea of their impact on an individual’s finances. To better understand the impact of loan interest, one can use a personal loan calculator.
Nonetheless, one should know that financial institutions do not use simple or compound interest calculations while deciding EMIs of a personal loan or any other credit instrument. Here the principal amount reduces with each EMI payment, which makes it hassle-free to repay credit.
What further elevates the loan experience is the availability of pre-approved offers.
Leading NBFCs such as Bajaj Finserv extend such offers to their current customers, thus streamlining the loan application procedure and saving time. These offers are accessible on financial products like business loans, personal loans, credit cards, etc. Applicants can now check their pre-approved offers by submitting their necessary contact details.
Simple interest and compound interest are traditional ways to calculate interest on any financial product. Nonetheless, before applying for a personal loan, or other loans in general, learn about the applicable interest and calculate it to make an informed decision.