Difference Between Simple Interest and Compound Interest - Interest is the amount to be paid on the amount borrowed by a person. Interest can be charged in two ways-
- Such interest, which is charged only on the Amount taken for Loan (borrowed), is called Simple Interest and
- Such interest, which is charged while adding loan amount + accumulated interest, is called Compound Interest.
Let's try to understand both of these types of interests, in a little detail, because the entire banking system is based on both of these types of interests.
Simple Interest Definition
Simple Interest is that which is charged as a predetermined percentage on Principal Amount (principal) for the entire Borrowing Period. This is the simplest way to calculate the interest on the borrowed amount, which leads to faster calculation of interest. Car Loan is the most common example of this type of interest because the interest in Car Loan is only charged at the Principal Amount, which is just borrowed.
The following formula is used to calculate Simple Interest.
Simple Interest = P*R*N Where as, P = Principal Amount R = Rate of Interest N = Number of Years
Let us understand the calculation of Simple Interest by an example. Suppose that you have lent Rs 20,000 to your friend for 2 years, on which you will charge simple interest according to 15% per annum, then after 2 years, your friend will return the amount of interest in addition to principal To find out, we can use Simple Form Calculating Simple Interest Calculate. where-
Principal Amount = 20000 Rate of Interest per Period = 15% Number of Years = 2 Yrs. Simple Interest = 20000 x 15/100 x 2 Simple Interest = 6000
That means your friend will pay a total of Rs 26000, in which Rs 20000 will be of Principal Amount and Rs 6000 will be of Simple Interest.
Whether interest is simple or compound, you have to keep in mind this particular thing about how you are putting interest rates, ie your friend will pay you interest annually (once a year), half yearly (twice a year ), Quarterly (Four times a year), Monthly (Monthly), Weekly (Per Week) or Daily (Per Day) on the basis of which, it will be decided on the basis of what interest it will have to give.
For example, suppose you take 15% interest from your friend annually but your friend will pay the interest on Half Yearly Basis i.e. twice a year. In that case, its Half Yearly Interest Rate will be only 7.5%.
As a result, if in our above example, though your friend lends money to you for a maximum of two years but for some reason his needs are met and he wants to pay your loan within 6 months, then in that case his interest The calculation will be based on 6 months and the interest rate will be halfway ie 7.5%. As a result, your friend will repayment only to you Rs 21500 as the interest of one year is 3000 rupees per 15% Annually interest rate, then the interest amount will be 1500 rupees for 6 months.
Rate of Interest (Time)
When we give money to someone in the form of a loan, then in return we take some Extra Amount in the form of interest. The rate at which Extra Amount is calculated, there is a special relationship with the timeline as we discussed in the previous section.
For example, when we deposit our Savings Account to a Bank's Saving Account, we are actually loaning to the bank on which the bank gives us interest at the rate of 4% in general but Bank gives us the interest, Half Annual Basis gives, therefore, every 6 months, in our Saving Account, calculates interest at exactly 2% of the Deposited Total Amount.
Compound Interest Definition
Compound Interest is an interest that is charged on the sum of Accumulated Interest of the Revised Principal Amount + earlier periods.
Under this method, add the interest obtained on Initial Principal to the Initial Principal Amount and make the mixture and next time the interest is calculated, then this time, instead of the principal, the mixture is given as Principal Amount. Is used. Simply put, compound interest is also known as interest on interest.
For example, Bank gives Compound Interest in our Saving Bank Account every 6 months at the rate of 4% annually on the Deposited Total Amount. So basically the bank pays compound interest at our rate of 2% on our Total Deposited Amount every 6 months. Let's try to understand the calculation of compound interest by an example, where we believe that 100,000 rupees are deposited in Saving A / c, on which the bank gives us 4% interest rate every 6 months is. In this situation-
Interest on first half = 10000 x 2/100 x 1 (half yearly) Simple Interest = 200
Since this 200 rupees interest accumulate, the bank is again deposited with Saving A / c, which again becomes the principal, hence the value in Vaastav now becomes Rs. 10200 instead of Rs. 10,000. As a result, when the bank re-calculates 6 months later, then-
Interest on second half = 10200 x 2/100 x 1 (half yearly) Simple Interest = 204
That is, the annual interest given by the bank for every half year at the rate of 4% on the amount of 10000 per year will be 200 + 204 = 404 rupees. However, if the bank gave simple interest instead of compounding, then in that case, the total Accumulated Simple Interest = 10000 x 2/100 x 2 (half yearly) = 400 would be the same as the accumulated interest in simple interest is not considered part of the principal i.e. Interest is not paid on interest
Manually calculating Compound Interest is quite complicated, so to do its calculation, the following Formula Use-
Compound Interest = P(1+R/N)^NT – P
Where as, P = Principal Amount N = Number of Compounding Per Year T = Number of Years R = Rate of Interest Per Period
Now if we calculate the bank interest of our previous example by this formula, then-
P = Principal Amount = 10000 N = Number of Compounding Per Year = 2 (Half Year) T = Number of Years = 1 R = Rate of Interest Per Period = 4% Yearly Compound Interest = 10000 x (1 + 4/100 x 2)^2 x 1 – 10000 Compound Interest = 404
You can understand that even after charging interest from the rate of interest on the Principal Amount, Compound Interest is more than 4 rupees compared to Simple Interest, because interest in compound interest is available on interest, and this This is also the biggest feature of interest, which is also called as the numbness of the world because no one can stop the power of Compound Interest, to make it rich.
What is Compounding of Power?
Let us try to understand this a bit better by an example.
Suppose that you have deposited your 10,000 rupees in any scheme, where you will get Compound Interest every six months from the Annual Interest Rate of 10%
Principal Amount = 10,000/- Interest Rate = 10% Annually Number of Years = 10 Yrs. Number of Compounding Per Year = 2 or Half Yearly Basis Compound Interest = P(1+R/N)^NT Compound Interest = 16,532.98
After 10 years due to Compound Interest, you will get a total interest of Rs 16532.98. But if this is the only Amount on this Amount to receive Simple Interest, then-
Principal Amount = 10,000 Rate of Interest per Period = 10% Annually Number of Years = 10 Yrs. Simple Interest = 10,000 x 10/100 x 10 Simple Interest = 10,000
After 10 years, you will get a total interest of Rs 10000 due to Simple Interest. It means that by changing the way you only calculate the interest calculating, you will have a loss of 16532.98 - 10000 = 6532.98 and this is happening because because when Compound is Interest Calculate, every time the interest is calculated, that interest will be added to the original Increases. As a result next time interest is calculated, you get interest on your last interest and that is the power of Compound Interest.
But you get the benefit of Compound Interest only when you do not take your interest every time that's the Interest Amount. If you withdraw your accumulated interest every time, your Principal Amount remains invested only, as a result of which as a result of the Compound Interest Scheme, that scheme remains really for you as a simple interest scheme.
Since all the strengths of Compound Interest are hidden in the fact that the accumulate interest again adds to the principal and increases the Actual principal, resulting in higher interest rates, as well as the next interest rate. Therefore, how quickly your Invested Amount will actually become, depends entirely on the fact that what is the Conversion Period of your Interest Calculation.
Time Interval between two Interest Payment Periods is known as Conversion Period. At the end of the Conversion Period, Interest Compound is done as follows.
| Conversion Period | Compounded |
|---|---|
| 1 Day | Daily |
| 1 Week | Weekly |
| 1 Month | Monthly |
| 3 Months | Quarterly |
| 6 Months | Semi-annually |
| 12 Months | Annually |
The lower the Conversion Period, your accumulated interest gets converted to the Principal Amount as soon as possible. Therefore, compound interest which is calculating 1/365% daily based on 1% annually will be more because your Principal Amount will increase daily in 1/365% Daily compared to 1% annually, because Accumulated Interest is your daily average Will be added to the principal.
This table means that if you charge the Compound Interest on Daily Basis, your Initial Principal Amount will be Daily Change and if you do weekly Charge Charge, then your Initial Principal Amount will change in every week. Similarly, if there is a Monthly, Quarterly Basis, if there is a Quarterly, Half Yearly Basis on Half Yearly and Annually Basis, then your Initial Principal Amount will change.
Generally banks do interest on the Half Yearly Basis, but there is a policy to have a Quarterly Interest Payment in the Financial Institution. Therefore, if you deposit 10000 rupees 8% annually in the bank FD, and your friend deposits with a 100,000 rupees 8% annual rate in any LIQUID FUND scheme, the interest you get to your friend, more than you Because, banks do calculate interest on Half Yearly Basis, while on Mutual Fund Companies, Quarterly Basis.
When we talk about Compound Interest, then we must be aware of the fact that we will pay interest on Daily, Weekly, Monthly, Quarterly, Half Yearly or Annually on what basis or when we will get interest paid , Because this conversion period has a tremendous impact on our interest and is done on the short term of interest calculation, the more interest is generated. But when we talk about Simple Interest, this conversion period does not matter to our Interest Amount, because interest is charged only at Principal Amount.
In conclusion, it can be said that-
- Interest is Fees, which is paid at a predetermined fixed rate in exchange for the use of someone else's money. There are many reasons for payment of interest such as Time Value of Money, Inflation, Opportunity Cost and Risk Factor etc.
- Simple Interest calculation can be done easily and easily because Principal Amount is same as ours, while Calculating Compound Interest is a bit difficult because Principal Amount changes.
- If you calculate Simple Interest and Compound Interest from the same Period, Amount and Interest Rate, then Compound Interest will be more than that of Simple Interest due to its Compounding Effect.
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