Simple & Compound Interest Definition
Interest is calculated on the invested or taken loan. There are two ways to calculate interest. 2 ways are simple interest (SI) and compound interest (SI). Simple interest is basically interest on a loan or investment. It is calculated on the amount of the principal. At the same time, CI is interest on interest. It is calculated on the amount of the principal as well as on the interest from the previous period. This article covers in detail the difference between simple and compound interest.
What is a Simple Interest and formula for Simple interest?
Simple interest (SI) is the cost of borrowing. It is simply the interest on the principal as a percentage of the principal. The borrowers will benefit from easy interest as they have to pay interest only on the loan taken. In further words, simple interest is the amount paid to the borrower for using the borrowed funds for a specified period.
One can easily calculate the simple interest by multiplying the total interest by the total holding and principal. Simple interests do not take into account past interests. It is based on the basic contribution amount only.
Vehicle loans and consumer loans use simple interest when estimating interest payments. Even certificates of deposit use simple interest to calculate return on investment.
Borrowers get higher interest than simple interest because there is no compounding power. In other words, there is no interest on interest. However, if their investment is based on simple interest then investors will suffer.
Formula:
Simple Interest=P×i×n
where:
P=Principal
i=Interest rate
n=Term of the loan
What is a compound Interest and formula for compound interest?
Unlike simple interest, which accrues interest only on the principal, compound interest (CI) derives interest from the interest earned earlier. Interest is added to the principal. CI is just interest on interest. The whole principle revolves around generating high returns by taking advantage of the interest earned on the principal.
In other words, CI has the potential to earn more than just interest on investment. Investment grows exponentially with compound interest because it depends on the primary power of compounding.
The bank or financial institution, or lender, decides the frequency of compounding. It can be daily, monthly, quarterly, semi-annually or annually. The higher the frequency of compounding, higher will be the amount of interest. Therefore, investors benefit more from compound interest than borrowers.
Banks use compound interest for some loans. But compound interest is more commonly used in investments. Similarly, compound interest is used for fixed deposits, mutual funds and any other investment that has a profitable reinvestment.
Formula:
A=P(1+r/n)^(n*t)-1)
Where,
A – Compound Interest
P – Principal Amount
r – the rate of interest
n – the number of compounding periods
t – number of years (duration)
Compound interest = total amount of principal plus future interest (or future value) minus current principal is called present value (PV). PV is the present value of a future amount or stream of money flows given a specified rate of return.
Continuing with the example of simple interest, what will be the amount of interest if interest is charged on a compound basis? In this case, it would be:
Example 1
Let’s understand CI calculation with an example. Mr. Rahul Sharma invests INR 10,000 at the rate of 10 percent for 5 years. One can compute the CI using the formula.
A = 10000*((1+10%)^(5)-1)
A = INR 6,105.