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Importance of Investments

Simple Interest Vs Compound Interest

Concept of Simple Interest

Simple Interest is the interest paid only on the principal amount borrowed. No interest is paid on the interest accrued during the term of the loan. 


There are three components to calculate simple interest: principal, interest rate and time.

 

Formula for Calculating Simple Interest

 

Interest = P x R x T 

 

  • I = Interest
  • P = Principal
  • R = Interest rate
  • T = Time

Example: Mr. X borrowed ₹10,000 from a bank to purchase a household item. He agreed to repay the amount in 8 months, plus simple interest at an interest rate of 10% per annum. If he repays the full amount of  ₹10,000 in eight months, the interest would be: 

 

P = ₹10,000; r = .10, t = 8/12

 

Applying the above formula, interest would be:

I= ₹10,000*(.10) *(8/12) = ₹667

 

This is the simple interest on the loan of  ₹10,000 loan taken by Mr. X for 8 months.

 

If he repays the amount of  ₹10,000 in fifteen months, the only change is w.r.t. time.

 

Therefore, his interest would be:

 

I = ₹10,000*(0.1) *15/12 = ₹1,250

 

Compound Interest

Compound Interest is the interest on a loan calculated on both the principal borrowed and interest earned. Interest is paid on the interest already earned.

 

Formula for Calculating Compound Interest

 

Amount = Principal x (1+interest rate) ^ (time)

 

Compound Interest earned = Amount – Principal = P{(1+r) ^ t-1}

 

Where,

  • P = Principal
  • r = Compound Interest Rate
  • t = Time 

Example: Mr. A borrowed ₹1,00,000 from a bank for his daughter’s education. He agreed to repay the amount in 2 years with an interest rate of 12% compounded annually. What is the interest paid by Mr. A?

 

After 2 years, Mr. A paid = 1,00,000*(1.12) ^2 = ₹1,25,440

 

Compound Interest = 1,25,440 - 1,00,0000 = ₹25,440

 

 

Albert Einstein once described compound interest as the “eighth wonder of the world,” let us discuss more on this in our next unit. 

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Units 15/16