All you need to know about simple and compound interest

Simple interest and compound interest are useful tools in different settings. Read on to know how

Deposits and borrowing are two opposite activities, but they have something in common: both attract ‘interest’. Interest applies to your contributions in fixed deposits (FDs) as well as your home and personal loans. It is the amount you earn or pay over and above your investments or loan amount, respectively. It is of two types: simple interest (SI) and compound interest (CI).

What is simple interest?

The cost of borrowing is called simple interest (SI). It is a type of interest calculation that does not consider numerous periods of interest payments or charges. In other words, the interest rate would only relate to the loan or investment's principal amount, not any accumulated interest.

What is compound interest?

Compound interest accumulates interest on the principal amount as well as the interest initially earned or paid on the principal amount. The applicable interest for a period is a function of the principal amount and the interest earned or paid in the previous cycle.

While compound interest is a helpful tool for your investments, it can work against you when you borrow money. Interest accumulates quicker than you can pay off the principal, leading to increased costs.

Simple interest vs compound interest

Simple interest and compound interest have fundamental and technical differences. Here are some of them:

· Simple interest is more straightforward to compute. The compound interest formula contains more variables and is, therefore, more difficult to calculate.

The formula to calculate simple interest is:

Simple interest = P*I*N

Where:
P: Principal amount
I: Interest rate for the period / 100
N: Tenure

The formula used to calculate compound interest is:

Compound interest = P [(1+i) n – 1]

Where:
P is the principal amount
i is the yearly interest rate
n is the number of compounding periods in a year

· As simple interest is calculated as a proportion of principle, the amount is always the same. Because we calculate compound interest as a proportion of the principal plus interest produced or accumulated to date, it varies from accrual period to accrual period.

· With simple interest, the principle stays the same. Compound interest is calculated by adding the compounded interest to the principal, increasing the principal amount.

· You will not be charged for outstanding interest with a simple interest loan because the interest charge and principal amount are constant for every accrual period.

· When you borrow money for items like auto loans, simple interest works better because the loan value is the same for each instalment.

Simple interest or compound interest: which is better?

Simple interest and compound interest have unique features. They both be helpful in different situations, although compound interest also allows you to benefit from compounding. Compounding essentially means earning interest on interest. It indicates that when earnings are reinvested, both the original investment and the reinvested profits rise simultaneously.

As a result, the investments multiply more quickly. It is referred to as compounding power. The greater the compounding rate, the better the investment returns will be. The number of times we compound interest in a year as compounding frequency.

Most banks like IDFC FIRST Bank use compounding to help you earn inflation-beating returns. With IDFC FIRST Bank, you can additionally use the full suite of digital services to invest, save, and spend money.

Compounding allows you to make your money work even harder for you. In the long run, the interest earns more interest. Also, the larger the return on an investment, the longer you stay invested. As a result, it is preferable to begin investing early to reap the benefits of compounding.

Disclaimer

The contents of this article/infographic/picture/video are meant solely for information purposes. The contents are generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. The information is subject to updation, completion, revision, verification and amendment and the same may change materially. The information is not intended for distribution or use by any person in any jurisdiction where such distribution or use would be contrary to law or regulation or would subject IDFC FIRST Bank or its affiliates to any licensing or registration requirements. IDFC FIRST Bank shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information mentioned. Please consult your financial advisor before making any financial decision.