simple interest and compound interest

What is Simple Interest? Formula, Calculator, Example, Definition

December 21, 2022 • 3779 views

A quick and easy method of calculating the interest charged on a loan is called Simple Interest. It is determined by multiplying the interest rate by the principal amount, by the number of periods(days/months/years) that have elapsed between the payments.
In layman’s term, simple interest definition can be explained as the rate at which you borrow or lend money. If a borrower takes money as a loan from a lender for a certain period, an extra amount of money is paid back to the creditor based on the rate of interest. This extra amount which is paid back to the creditor for availing the loan is called the interest component.

What is a Simple Interest Calculator and How Does it Works?

A simple interest calculator can be a digital tool that calculates the interest on loans without compounding. For calculating the same you must enter the principal amount, interest rate, and tenure. Digital calculator will display EMI (Equated Monthly Instalments) on the loan. You can use this calculator to measure interest on the principal amount on a daily, monthly, or yearly basis. This digital calculator can be found in many financial institutes or aggregator website.

The simple interest calculator is programmed to work on the mathematical simple interest formula also which looks like this:

Simple Interest = (P×I×N)/100

where:

P=Principal amount borrowed

I=Interest rate (Yearly)

N=Number of periods that elapse between payments e.g., if it is a 6-month period and the total tenure is 1 year then there will be 2 periods.

Here is a simple interest formula example for better understanding of the formula: Let’s assume a student obtains a simple interest loan to pay one year of university tuition, which costs Rs. 50,000. And the annual interest rate for the loan is 7%. The student repays the loan in 5 years and each period is equal to 1 year. Then using the formula amount of simple interest paid is calculated as follows:

Rs. 17,500 = Rs. (50,000 x 7 x 5)/100

And the total amount to be paid by the student will be:

Rs. 67,500 = Rs. 50,000(Principal Amount) + Rs. 17,500 (Interest Amount)

This example will help you understand simple interest meaning more clearly.

Also Read: Personal Loan Vs. Line Of Credit: Which Is Better?

What Types of Loans Use Simple Interest Formula?

Simple interest mostly applies to staff loans which is provided by organization to its staff. The interest is calculated on the principle. However, there is no interest that is calculated on the accrued interest.

It is also used for Education Loans in certain lenders. In pure business terms, simple interest is beneficial to the borrower and not for the lender. Hence, it is not a preferred repayment method for lenders.

Simple interest is often calculated daily, therefore it mostly benefits people who have a daily inflow in money to pay their loans on or before time.

What is Compound Interest and How it is Related to Simple Interest? 

Interest charged on a particular loan can be simple or compounded in nature. Repayment amount calculation for a Simple Interest is based on current principal amount whereas, for a Compound Interest calculation for EMI is based on the principal amount and the interest that accumulates on it in every cycle. This is the major difference between simple interest and compound interest.

Compound interest is used by all major lenders to calculate the repayment amount on an Online Personal Loan and Business Loan of a borrower.

Compound Interest Formula 

Compound interest is defined as below:

Compound Interest = Total Amount – Principal

Here Total Amount (A) can be calculated using the formula given below:

A=P (1+r/n)^nt

where,

P = Principal amount

r = rate of interest

n = number of times interest is compounded every year

t = time period

Example – Let’s assume a borrower takes a loan of Rs. 2000 for 1.5 years at 10%p.a. Now we need to calculate the compound interest paid for the loan half-yearly.

Then using the compound interest formula,

Principal, P = Rs.2000

Time, t= (3/2) years

Rate, r = 10%

Frequency, n=2 as the loan is paid half-yearly

Total Amount, A can be calculated as:

A=P (1+r/n)^nt

 A=2000 (1+10/200)^3 

A = Rs. 2315.25

Compound Interest = A – P = Rs.2315.25 – Rs.2000 = Rs.315.25

Simple Interest or Compound Interest: Which is Better?

Parameter

Simple Interest

Compound Interest

Definition

Simple interest can be defined as the amount of interest charged on a principal amount at a given rate and for a given period.

Compound interest can be simply defined as the interest calculation based on the initial principal amount plus the interest accumulated to the principal balance at a given rate and for a given period.

Formula

S.I. = (P × T × R) ⁄ 100

Compound Interest = Amount – Principal

A=P (1+r/n)^nt

Repayment Amount

The repayment amount is much lesser compared to compound interest.

The repayment amount is higher compared to simple interest.

Growth

The interest component increases uniformly.

The interest component increases at a faster rate compared to compound interest

Interest Charged

The interest rate is only charged on principal amount.

The interest rate is charged on the principal and accumulated interest.

 

Also Read: Choosing the right loan for you: Personal Loans vs. Top-up Loans

What are the Benefits of Simple Interest Vs Compound Interest?

Simple interest loans have many benefits. When we make a repayment for a simple interest loan, the payment will go towards interest and principal amount both. In a compound interest scenario, during repayment the interest component is paid first and only when it interests payment is done remaining amount goes towards payment of principal.

Below it has been described in detail:

  • Easy Calculations – The calculation for simple interest is quite simple and straightforward. We must multiply principal amount borrowed by interest rate of borrowed amount by the number of periods and finally divide the output by 100. Whereas calculation of compound interest is comparably complex. For calculating compound interest, we need to first calculate the total amount to be paid over a period, based on the rate of interest, tenure, and the initial principal. After getting total amount, we subtract principal amount from total amount to get Compound interest.
  • Interest - Interest is always more for compound interest when compared to simple interest.
  • Advantageous for Borrowers – Borrowers must make lower interest payments in case of simple interest compared to compound interest. This makes it more beneficial for borrowers.

Key Takeaways 

  • Simple interest is a basic and easy method to calculate the cost of debt.
  • Simple interest can be calculated by multiplying the principal amount by the rate of interest and by the time between the payments. The result should be subsequently divided by 100 to deduce the final interest amount.
  • Although compound interest calculation is more complex compared to simple interest still most cases during loan offering by lender it is offered using compound interest only.
  • Lastly, understanding the concept of simple and compound interest will help you when you are applying for an Online Personal Loan.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
*Terms and Conditions apply

poonawalla fincorp team

Poonawalla Fincorp Team

Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.

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