Simple vs Compound Interest
When you invest, understanding how interest is calculated can significantly impact your returns. Two of the most common methods are simple interest and compound interest—and the difference between them can mean thousands of rupees in earnings over time. Whether you're a conservative investor or planning for long-term growth, grasping this concept is key.
What is Simple Interest?
Simple Interest (SI) is the interest calculated only on the principal amount — the original sum of money borrowed or invested. It does not consider any previously earned interest, meaning the interest payment is the same every period.
Formula for Simple Interest:
SI = P × R × TWhere:
- P = Principal (the original amount)
- R = Rate of Interest (per annum, in decimal)
- T = Time (in years)
Example of Simple Interest:
Suppose you invest ₹1,00,000 in a bond with a simple interest rate of 10% per annum for 3 years.
Calculation:
SI = 1,00,000 × 0.10 × 3 = ₹30,000
Total Amount after 3 years = Principal + SI = ₹1,00,000 + ₹30,000 = ₹1,30,000.
What is Compound Interest?
Compound Interest (CI) is the interest calculated on both the principal and the accumulated interest from previous periods. This "interest on interest" effect allows your investment to grow at an exponential rate. It is commonly used in savings accounts, fixed deposits, and long-term investments.
Formula for Compound Interest:
A = P(1 + r/n)ntCI = A - PWhere:
- A = Amount after time t
- P = Principal amount
- r = Annual rate of interest (in decimal)
- n = Number of times interest is compounded per year
- t = Time (in years)
Example of Compound Interest:
Suppose you invest ₹1,00,000 at an interest rate of 10% per annum, compounded annually for 3 years.
Calculation:
Amount (A) = 1,00,000 * (1 + 0.10/1)1*3 = 1,00,000 * (1.1)³ = ₹1,33,100
Compound Interest (CI) = A - P = ₹1,33,100 - ₹1,00,000 = ₹33,100.
Difference Between Simple Interest and Compound Interest
| Feature | Simple Interest | Compound Interest |
|---|---|---|
| Basis of Calculation | Calculated only on the principal | Calculated on principal + accumulated interest |
| Growth | Linear | Exponential |
| Total Amount | P + (P × R × T) | P(1 + r/n)nt |
| Interest Earned | Same every year | Increases every compounding period |
| Common Uses | Short-term loans, car loans | Savings, fixed deposits, long-term investments |
Key Takeaways
- For borrowers, a simple interest loan is generally cheaper.
- For investors, compound interest generates significantly higher returns over the long term.
- The higher the compounding frequency (e.g., monthly vs. annually), the greater your returns.
- Over time, the difference in total earnings between simple and compound interest becomes substantial.