As an investor or borrower, you must have encountered the terms, simple interest and compound interest at several points. These are ways of calculating the interest that the lender levies on the amount you borrow from them. The interest on loans provided to borrowers can be computed using simple and compound interest formulas.
Simple interest is where the interest is calculated on the principal amount of the loan or deposit. It is fixed and remains the same for the stated period. On the other hand, compound interest is calculated based on the principal amount and the interest accrued. The interest does not remain the same – it increases every year if the interest is not paid out to the client or investor. The compound interest reduces where a loan is issued, and the fee paid to the lender also decreases as the principal amount given reduces.
Since simple interest and compound interest
are different, the formulas used in deriving the amount to be paid as interest are also different.
Simple interest formula
The formula for calculating simple interest is –
Simple interest = P x R x N
In this formula, P stands for the principal amount, R for the annual interest rate, and N stands for the loan term in years. If you are given a loan of Rs. 1000 at a rate of 7% for two years, here is how your simple interest will be calculated
Simple interest = 1000×0.07×2
This means that the simple interest will be Rs. 140. In this scenario, the total amount paid will be Rs. 1000, which is the principal amount plus interest of Rs. 140. Thus, you get a total of Rs. 1140.
Compound interest formula
Here is the formula used for calculating compound interest –
Compound interest A=P (1+r/n)nt
Stands for the final amount, P is the initial principal balance, R is the interest rate, N is the number of times interest is applied per period, and T is the number of periods elapsed.
Where simple interest is used
Simple interest is mostly used by financial institutions to calculate the fees on short-term loans. These types of loans include personal loans, car loans, and in some cases home loans. For the borrower, simple interest is more advantageous. When simple interest is used to calculate interest on loans, the fee paid by the borrower is usually lower because the interest is only calculated based on the initial principal.
Since simple interest does not accrue over time, it is not the best option for investors as the interest earned will be lower compared to compound interest. The amount of interest that one can earn from an investment is significant. This is what determines the returns that you will get. Therefore, the interest rate should be considered by a borrower but not by an investor.
When you take a loan from a bank for trading or business and the interest you are required to pay is high, you may not get any tangible returns.
Where compound interest is used
Compound interest is mainly used on student loans, mortgages, and other types of loans. Unfortunately, borrowers who don’t pay their interests in time may end up paying more in terms of accrued interests, which is why compound interest is a good way for banks or lenders to earn more profits.
Investors are the big beneficiaries when it comes to compound interest. It is great for long-term investments, especially when the interest earned is not paid out but instead re-invested. Unlike simple interest, which is calculated based on the principal amount, compound interest adds the interest earned to the initial principal.
Compound interest helps companies to maximize profits. By offering lower interest rates, they can attract more investors, resulting in more profits. This is also an excellent option for pension schemes where the employees’ money accumulates until retirement when they are paid the entire accrued amount.
Need more related to simple interest and compound interest, Contact anytime Bajaj Finserv Customer Care Number
Considering simple and compound interest formulas, both serve the purpose well when it comes to calculating interest. Simple interest is an advantage to borrowers as it enables them to pay lower interest rates. For the investor, the returns are less when simple interest is used.
Go to Homepage