05 Jan 2021

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.

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.

## What is the simple interest formula?

Simple interest is calculated as a percentage of the principal wherein the period remains constant. As such, the formula to calculate SI 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.

## 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.