Compound Interest and Simple Interest

Compound interest is the interest on a loan or a deposit that is computed using both the original principal and the interest accrued over time. Compound interest, which is also known as “interest on interest,” has been in use since the 17th century in Italy. It is computed by multiplying the original principal amount by the compounded interest rate.

The interest rate on a loan may be calculated quickly and easily using simple interest. In order to calculate simple interest, you must multiply the daily interest rate by the principal and the number of days since the last payment. In this article, we will discuss the difference between simple interest and compound interest, their formulas, and solve some questions. 

Compound Interest and Simple Interest

Interest can be defined as the rate of return on a deposit. For example, if you take out a loan and pay a monthly interest rate, you are paying for borrowing money. Compound interest and simple interest are two methods of calculating interest.

The original amount of a loan is used to compute simple interest. Compound interest is defined as “interest on interest” since it is calculated on both the principal and the accumulated interest from prior periods.

When interest is computed on a compound basis rather than a simple basis, the difference in the amount owed might be substantial. When it comes to your assets, the power of compounding may work in your favour and help you build wealth.

Simple interest and compound interest are fundamental financial concepts, and understanding them may help you make better choices when it comes to borrowing money or investing.

Difference Between Compound Interest and Simple Interest

Borrowing money incurs a charge from a lender, which the borrower pays back. As a percentage, interest is often stated as simple or compounded. The principle of a loan or deposit is used to calculate simple interest. Compound interest, on the other hand, is based on the sum of the principal and the interest that accrues on it over time. When calculating simple interest, it is important to keep in mind that it only takes into account the amount of the original loan or deposit.

Compound Interest and Simple Interest Formula

Simple Interest 

SI = P x t x r whole divided by 100, where P is the principal amount, t is the time period, and r is the rate of borrowing. 

For example, if you take a loan of Rs. 1,00,000 at 9% interest for a period of 10 years, what will the simple interest be?

SI = P (principal amount = Rs. 1,00,000) x t (time period = 10 years) x r (rate of interest = 9)

So, 1,00,000 x 10 x 9 / 100 = 90,000. 

The simple interest will be Rs. 90,000/-

Compound Interest

CI = P (1 + r/n)t, P is the principal amount, r is the rate of interest, n is the number of times that the interest is compounded every year, and t is the time period. 

For example, if you borrow Rs. 5,00,000 at 8% interest for 7 years and interest is compounded twice every year, what will the compound interest be?

CI = 5,00,000 x (1 + 8/2)7

= 5,00,000 x (1+ 4)7 – P

= 5,00,000 x 5 x 7 – P

= 17,50,000 – 5,00,000 = 12,50,000 

The compound interest will be Rs. 12,50,000/-

Concepts Related to Interest

Time Value of Money

Because money is not “free” but rather, has a cost in the form of interest, one Rupee now is worth more than one Rupee at a future date. A sophisticated approach, like discounted cash flow (DCF) analysis, has its roots in this idea, which is called the “time value of money”. The reverse of compounding is called discounting. 

Rule of 72

At a given rate of return or interest, the Rule of 72 determines how long it will take for an investment to double. Even though it is limited to annual compounding, this method may be useful when trying to figure out how much money you will need in retirement.

In 12 years, an investment with a 6% yearly return, for example, will have doubled in value (72 years x 6%). In nine years, an investment with an annual rate of return of 8% will have doubled in value.

Conclusion

When you take out a loan and pay a monthly interest rate, you are paying for borrowing money. Interest can be the rate of return on a deposit or a withdrawal. Compound interest and simple interest are two methods of calculating interest.

Compound interest will work in your favour if you invest consistently and pay off your debt more frequently. Simple interest and compound interest may save you tens of thousands of Rupees and increase your net worth over time, if you understand their fundamentals.