Interest, whether earned or incurred, is an essential part of any financial undertaking. It applies to both investments and loans. For investments, the interest indicates the amount you can earn with the instrument. On the other hand, interest is how much you’re liable to pay the lender for borrowing the chosen amount with loans. There are two main types of interest applicable here: simple interest and compound interest. Knowing the difference between compound and simple interest is important for everyone.
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However, while investors are acquainted with the effect of compound interest, borrowers may not be well-informed. So, the focus here is to understand how simple interest and compound interest impact borrowing. When you take a loan, the way your interest gets calculated plays a crucial role in your total outgo. With equal terms, when comparing simple interest vs compound interest, you’ll find that the simple interest option will always result in lower outgo.
With loans, compound interest is usually applied to outstanding credit payments. As a result, you end up paying a lot more in comparison, which is why you should try to avoid it at all costs. To better understand the difference between compound and simple interest, consider the definitions of these terms, simple and compound interest formula.
What is simple interest?
To put it briefly, simple interest is the interest calculated as a percentage of the principal amount for a given period. In this case, none of the variables undergoes any change and remains constant all through. It is the quickest way to know the interest payable on a loan, and manual calculations are quite easy.
Additional Read: How to calculate Loan EMI on calculator
What is the simple interest formula?
Simple interest is calculated as a percentage of the principal wherein the period remains constant. As such, the simple interest formula is:
SI = P * i * n
Here,
P = principal
i = annual interest rate
n = tenor in years
To give you a better understanding of SI, here is the formula in action. Consider a loan of Rs. 1.2 lakh taken at an interest rate of 13% for a tenor of 3 years. So, based on these variables:
SI= 1,20,000*0.13*3
SI= 46,800
This is the total interest payable after 3 years for the given principal amount.
Additional Read: Compute Your Simple Interest Amount with Simple Interest Calculator
What is compound interest?
Compound interest is hugely different from simple interest because here, you incur interest on interest. With compound interest, interest is charged on the revised principal, which contains the prior interest incurred. Here, the value of the principal changes based on the compounding period. Compounding interest is used to calculate interest payable in the case of certain types of credit. It is important to note that the total payable with compounding interest will be higher than that payable with simple interest.
What is the compound interest formula?
To Calculate compound interest, the formula is as follows.
CI = P[(1+i)n −1]
Here,
P = Principal
i = annual interest rate
n = compounding period in years
Considering the same case as above, on a loan of Rs. 1.2 lakh taken for three years at a 13% rate, below is the CI for three years. Do note that for this example, the interest is compounded annually.
Year |
Opening Balance (P) |
Interest payable (I) |
Closing balance (P+I) |
1 |
Rs. 1.2 lakh |
Rs. 15,600 |
Rs. 1,35,600 |
2 |
Rs. 1,35,600 |
Rs. 17,628 |
Rs. 1,53,228 |
3 |
Rs. 1,53,228 |
Rs. 19,919 |
Rs. 1,73,148 |
Compound interest |
Rs. 53,148 |
As you can see, the difference between CI & SI for three years is Rs. 6,348. The formula of difference between CI and SI is ‘CI-SI’, which will get you the above-mentioned value.
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Simple Interest Vs Compound Interest
The main difference between compound and simple interest is that the principal amount changes based on the compounded period with compound interest. With simple interest, all the variables, including the principal, remain static all through the period. Another key difference to note is that compound interest will yield higher earnings with investments but conversely increase the cost of borrowing in the case of credit. However, with simple interest, loans will have lower interest outgo, and investments will yield less in comparison.
Pitting simple interest vs compound interest helps you understand financial instruments and how they impact your financial health over time. While compound interest is common with investments, you should know that neither compound interest nor simple interest is the norm with loans. Loans like Bajaj Finserv Personal Loan make use of a reducing balance calculation in which the principal reduces over the tenor with each EMI payment made. Check your eligibility and apply for personal loan online. Further, you can use the Loan EMI calculator to see how this calculation mode even betters simple interest calculations.
Bajaj Finserv offers funding up to Rs. 40 lakh for a tenor of up to 96 months. You can enjoy loan perks such as expedited loan processing and complete loan disbursal within 24 hours with a sound financial profile. This makes it a loan you can count on, even when faced with an emergency. To enjoy the benefits of this offering, check your pre-approved offer today for a hassle-free experience.
Read More: Differences between flat and reducing interest rate
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