Simple and compound interest are two forms of interests a lender can charge the borrower. Interest is the fee that the borrowers must pay to their lenders on principal amount. The borrower can be a person who is applying for a home loan. The lender can be a person who has a fixed deposit account. There are different forms of lenders and borrowers. Interest is the profit made from the investment. It is made in two forms, simple and compound.
Interest rate is the percentage at which the interest is charged. It is the charge levied on the cost of renting the principal amount. One of the factors that impact the interest rate is inflation. The credibility of the borrower factors in as well.
Simple interest is the interest levied on the principal amount. The simple interest rate is charged every year on the principal amount at a percentage. It is normally levied upon fixed deposits, loans, etc. Simple interest doesn’t earn interest on interest. The interest is charged only on the principal amount and is fixed.
If the borrower has applied for a loan, then they will have to pay interest on the amount borrowed. The lender will earn interest on the principal amount if they have invested in a fixed deposit, recurring deposit, etc. The interest will only be charged on the first principal amount and not after every term.
Simple Interest Calculator–
P = Principal
R = Rate of Interest
T = Loan or Deposit term in years
Simple Interest = P x R x T/100
Compound interest is interest levied on interest and principal amount. The interest from a term is added to the principal amount in the new term. Only after that, compound interest is levied on the total. There are different terms on which interest can be compounded. The terms are annually, quarterly (four times in a year), monthly (12 times in a year), weekly (52 times in a year), and daily (365 times in a year).
P = Principal
R = Rate of Interest (in decimal)
N = Number of Times the Interest is compounded
T = The Term of Loan or Deposit
A = Amount
A = P(1+R/N)(NT)
For example, a person invests Rs. 1 Lakh in a fixed deposit for 2 years. The interest rate is 10% per annum. After one year, the interest will be added to the principal amount and it will be around Rs. 1.10 Lakh. The interest for the next year will be compounded on Rs. 1.10 Lakh and not Rs. 1 Lakh. After the term, the total amount will be around Rs. 1.21 Lakh.
Some Differences Between Compound and Simple Interest–
- Principal Amount
Compound interest is calculated by adding interest to the principal amount. The principal is different at the end of the term. However, simple interest is calculated only on the principal amount.
The term impacts the compound interest rate. If the terms are more, then the compound interest rate will get more profits. However, the profits from simple interest will not increase if the terms are more.
The profits can be high if the investor earns them at a compounded rate of interest as the principal amount increases every term. However, simple interest will not earn the investor high returns.