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Know The Difference Between Simple Interest Vs Compound Interest

  • Highlights

  • With compound interest, you incur interest on interest

  • Simple interest results in lower interest for loans

  • Reducing balance loan is cheaper than simple interest loan

  • Bajaj Finserv Personal Loan uses reducing balance method

Interest, whether earned or incurred, is an especially important 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, with loans, the interest is how much you’re liable to pay the lender for borrowing the chosen amount. There 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 so informed. So, the focus here is on how simple interest and compound interest impact borrowing. When you take a loan, the way your interest gets calculated plays a key 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, take a look at the definitions of these terms as well as the 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 undergo any change and remain constant all through. As such, 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 formula to calculate SI is:

SI = P * i * n

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: 4 Ways to get the best personal loan interest rate

What is Compound Interest?

Compound interest is hugely different from simple interest in the sense that here, you incur interest on interest. To put it simply, 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]

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 3 years at a 13% rate, below is the CI for 3 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.1,20,000 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 3 years is Rs.6,348. The formula of difference between CI and SI is ‘CI-SI’, which will get you the above-mentioned value.

Additional Read: How You Can Use a Personal Loan Calculator


What is the Difference Between Simple Interest and Compound Interest?

The main difference between compound and simple interest is that with compound interest, the principal amount changes based on the compounding period. 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 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 the 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 personal loan online. Further you can use the Loan EMI calculator to see how this mode of calculation even betters simple interest calculations.

Bajaj Finserv offers funding up to Rs.25 lakh for a tenor of up to 60 months. With a sound financial profile, you enjoy loan perks such as expedited loan processing and complete loan disbursal within 24 hours. 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.

The content of this document is meant merely for information purposes. The personal loan features mentioned in this article are subject to updation, completion, revision, verification and the same may change materially based on policy revisions. For more details, please visit our Personal Loan terms and conditions page here.

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