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So, simple interest is the sum paid for using the borowed money, for a fixed period. On the other hand, whenever the interest becomes due for payment, it is added to the principal, on which interest for the succeeding period is reckoned, this is known as compound interest. So, here in this article, you will find the basic differences between Simple Interest and Compound Interest, which we have compiled after an in-depth research on the two terms. Content: Simple Interest Vs Compound Interest
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Definition of Simple InterestSimple Interest is the interest which is charged as a percentage of the original amount lent or Principal, for the whole borrowing period. Interest is the price paid for the use of funds or income received from lending the funds. It is the easiest and fastest method to calculate the interest on the amount lent or borrowed. The most common example of Simple Interest is the car loan, where interest has to be paid only on the original amount lent or borrowed. The following formula is used to calculate the amount of interest: Formula: Simple Interest = P×i×n Where P = Principal Amount i = rate of interest n = number of years For Example: If you borrow Rs. 1000 from your friend @ 10% per annum for 3 years, then you have to return Rs.1300 to your friend at the end of 3rd year Rs 1000 for Principal and Rs. 300 as interest, for keeping the amount with yourself. If we add up the principal and interest, then it will be known as Amount. One thing should be kept in mind is, the more the money and periods, the higher will be the interest. Definition of Compound InterestCompound Interest is the interest which is computed as a percentage of revised principal, i.e. Original principal plus accumulated interest of prior periods. In this method we sum up the interest earned in the previous years to the initial principal, thus increasing the principal amount, on which the interest for the next period is charged. Here, interest is to be paid on the principal as well as the interest accrued during the loan term. The time interval between two interest payment period is known as Conversion Period. At the end of the conversion period the interest is compounded like:
Normally, the banks pay interest on half yearly basis, but financial institutions have the policy of paying interest quarterly. For computing compound interest you have to use this formula: Formula: Compound Interest = P {(1 + i)n – 1} Where, P = Principal n = number of years i = rate of interest per period
The following are the major differences between simple interest and compound interest:
Video: Simple Vs Compound InterestExampleSuppose Alex deposited Rs. 1000 to a bank at 5% interest (simple and compound) p.a. for 3 years. Find out the total interest that he will get at the end of the third year? Solution: Here P = 1000, r = 5% and t = 3 years Simple interest = Compound interest = ConclusionInterest is the fee for using someone else’s money. There are many reasons for paying interest like time value of money, inflation, opportunity cost, and risk factor. Simple Interest is quick to calculate, but Compound Interest is practically difficult. If you compute, both simple interest and compound interest for a given Principal, Rate, and Time, you will always find that compound interest is always higher than the simple interest due to the compounding effect on it.
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Interest is calculated on the investment or loan taken. There are two ways one can calculate interest. The two ways are simple interest (SI) and compound interest (CI). Simple interest is basically the interest on a loan or investment. It is calculated on the principal amount. At the same time, Compound Interest is the interest calculated on interest. It is calculated on the principal amount as well as the previous period’s interest. This article covers the difference between simple interest and compound interest in detail. What is Simple Interest?Simple interest (SI) is the cost of borrowing. It is the interest only on the principal amount as a percentage of the principal amount. Borrowers will benefit from simple interest as they have to pay interest only on loans taken. In other words, simple interest is the amount that one pays to the borrower for using the borrowed money for a fixed period. One can easily compute Simple interest by multiplying the interest amount with the tenure and the principal amount. Simple interest doesn’t consider the previous interest. It is simply based on the original contribution amount. Car loans and consumer loans use simple interest while estimating the interest payments. Even a certificate of deposit uses simple interest to calculate the return from the investment. Borrowers benefit more from simple interest as there is no power of compounding. In other words, there is no interest on interest. However, investors might lose if their investments are based on simple interest. What is the formula for Simple interest?Simple interest is computed by multiplying the interest rate for a period by the principal amount and the tenure. The tenure can be in days, months, or years. Hence the interest rate has to be converted accordingly before multiplying with the principal amount and tenure. One can use the following formula to calculate the simple interest: Simple Interest = P*I*N Where, P – Principal Amount I – Interest Rate for the period N – Tenure Example 1Let’s understand simple interest with an example. Ms Devika invests INR 1,00,000 in a fixed deposit for a tenure of three years at a 7% interest rate. Using the formula of simple interest, we can calculate the interest Ms Devika will earn from the investment. Simple Interest = INR 1,00,000*7%*3 years Simple Interest = INR 21,000 For her investment, Ms Devika receives INR 21,000 at the end of three years (investment tenure). The bank or the financial institutions pays Ms Devika an interest of 7% for using her deposit amount for its operations during the tenure of her investment (three years). The INR 7,000 is the interest that Ms Devika receives on her deposit from the borrower. The simple interest should be calculated according to the duration of the investment or loan. If a loan is only for a few days or months, the interest rate has to be converted into a daily or monthly basis. Let’s take an example of a loan that charges interest on a daily basis to understand it better. Example 2The principal amount of a loan is INR 50,000, of tenure of 60 days, with an interest rate of 5% per annum. One can compute the simple interest, in this case, as follows. Principal amount – INR 50,000 Tenure – 60 days Interest rate – 5% per annum or 0.014% per day. Simple interest = INR 410.95 Therefore, the total interest the borrower will pay for the INR 50,000 loan for a tenure of 60 days is INR 410.95. It is important to note that the higher the amount, the higher will be the interest. Also, the higher the duration of the investments, the greater will be the interest. What is Compound Interest?Unlike simple interest, which gains interest only on the principal sum, compound interest (CI) earns interest on the previously earned interest. The interest is added to the principal amount. CI is simply Interest on Interest. The whole principle revolves around generating high returns by compounding the interest received on the principal sum. In other words, CI has the potential to earn more return than just the simple interest from an investment. The investments grow exponentially with compound interest because it is based on the principal power of compounding. The bank or financial institution, or the lender decide on the frequency of compounding. It can be daily, monthly, quarterly, half-yearly or yearly. The higher the frequency of compounding, the higher will be the interest accrual amount. Hence, investors benefit from compound interest more than borrowers. Banks use compound interest for some loans. But compound interest is most commonly used in investments. Also, compound interest is used by fixed deposits, mutual funds, and any other investment that has reinvestment of profits. What is the formula for compound interest?CI is calculated by multiplying one plus interest raised to the power of the compounding periods with the principal amount. Finally, the principal amount has to be subtracted to obtain the CI. One can use the following formula to calculate compound interest: 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) Example 1Let’s understand CI calculation with an example. Mr Charan invests INR 10,000 at the rate of 10% for five years. One can compute the CI using the formula. A = 10000*((1+10%)^(5)-1) A = INR 6,105. The interest earned by Mr Charan is INR 6,105. The corpus at the end of his investment tenure is INR 16,105 (the principal and the interest). On the other hand, the simple interest for the same investment and tenure is INR 5,000. The difference between SI and CI amount is INR 1,105. Example 2If the frequency of compounding is higher, then the interest will be higher. Also, if the investment duration is higher, the returns will be higher as well. Let’s take the same example as above but with higher compounding periods to understand how the interest will be higher in this case. Investment – INR 10,000 Interest – 10% per annum Tenure – 5 years Compounded – half yearly, therefore the compounding periods are 2 A = 10000*((1+10%/2)^(5*2)-1) A = 10000*((1+5%)^(10)-1) The CI in this case, for Mr Charan is INR 6289. The corpus at the end of his investment tenure is INR 16,289 (the principal and the interest). Mr Charan earned INR 183 extra in this case. Hence with higher compounding periods, the interest will also be higher. Also, one can use the Scripbox’s Compound Interest Calculator to determine the values faster. Explore Best Banks in India What is the power of compounding?Compounding refers to a scenario where interest earns interest. It simply means when earnings are reinvested, the initial investment and the reinvested earnings grow at a constant rate. This makes the investments multiply at a faster rate. This is called the power of compounding. The higher the compounding frequency, the higher will be the returns from the investment. Compounding frequency is the number of times the interest is calculated in a year. Compounding is a compelling concept, and no wonder Albert Einstein called it the 8th wonder of the world. Under compounding, you can make your money work harder for you. The interest that accumulates earns more interest in the long term. Also, the longer you stay invested, the higher will be the return from an investment. Hence it is advisable to start investing at early ages to benefit from the power of compounding. Difference Between Simple Interest and Compound Interest?Following are the key differences between simple interest vs compound interest:
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