The concepts of simple interest and compound interest could confuse you if you aren’t aware of the finer details. Let's look at the differences, including the compound interest rate formula. The simple interest rate is calculated annually on the initial principal amount alone for the entire period. When you calculate compound interest using the compound interest rate formula, you combine both the principal and the previous interest. An initial principal of Rs. 100 with a simple interest of 10% per year for 5 years would result in a simple interest rate of Rs. 10 per year, with a total amount after 5 years of Rs. 150. As an alternative, compounding at the same rate after 5 years will result in a total of about Rs. 161. The interest after the 1st year is calculated on Rs. 10. After the second year, the compound interest will be calculated on Rs. 110 instead of Rs. 100, and so on until the loan is paid off. For that same interest rate and principal amount, the amount will be higher after 5 years if compounded. How to calculate Simple interest is the interest you pay on a principal amount you borrow SI = P (Principal amount) × R (Rate of Interest) × T (Time) Compound Interest is the interest on the principal added to the unpaid interest P (Principal Amount) (1+r/n) > (nt) In this formula, n 'refers to number of instances when interest is applied', r 'refers to the interest rate', and t 'refers to the tenor or time'. Uses of simple interest - The benefit of simple interest as a borrower is that it keeps your overall loan payment lower than if you paid compound interest.
- Using simple interest increases borrowers' savings because they pay less overall in interest compared to compound interest.
- Simple interest is calculated as the loan balance dips each month with each payment, as in the case with car loans, amortized monthly, and retailer instalment loans.
- Deposit certificates (CDs) pay interest at a set rate on a specific date.
Uses of compound interest - Savings, checking, and certificate of deposit accounts. The interest you earn on a deposit into a savings account at a bank is added to the account balance when you make a deposit.
- Taking advantage of compounding in your own savings accounts and investments will also earn you money over time. Every business day, a stock's performance is compounded based on the percentage gains made the day before.
- It is not in your favor to borrow when compound interest is involved. Any money you do not pay back when you borrow it accrues interest. The interest charges which you do not pay within the loan's payment period are "capitalized," meaning they are added to your initial loan balance.
- You pay interest on your credit card balance every month based on the result of the compound interest rate formula. In this case, your balance will remain the same as long as you pay the accrued interest each month. But if you don’t pay enough to cover the month’s new interest, it will be added to your credit card balance.
Read Also: What is annual percentage rate and how to calculate it? Read Also: What are the Differences Between Simple Interest and Compound Interest?
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## AuthorAman Khanna is an experienced financial advisor who is well known for his ability to foretell the market trends as well as for his financial astuteness. He has an MBA in finance from Toronto University as well as years of experience delivering seminars on sound financial practices and debt management. |