Simple Interest vs. Compound Interest

 INTRODUCTION

Interest is the cost of borrowing money, where the borrower pays a fee to the lender for the loan. The interest, typically expressed as a percentage, can be either simple or compounded. Simple interest is based on the principal amount of a loan or deposit. In contrast, compound interest is based on the principal amount and the interest that accumulates on it in every period. Simple interest is calculated only on the principal amount of a loan or deposit, so it is easier to determine than compound interest.

SIMPLE INTEREST

Simple interest is calculated using the following formula:

$\begin{aligned} &\text{Simple Interest} = P \times r \times n \\ &\textbf{where:} \\ &P = \text{Principal amount} \\ &r = \text{Annual interest rate} \\ &n = \text{Term of loan, in years} \\ \end{aligned}$



Generally, simple interest paid or received over a certain period is a fixed percentage of the principal amount that was borrowed or lent. For example, say a student obtains a simple-interest loan to pay one year of college tuition, which costs Rs. 18,000, and the annual interest rate on the loan is 6%. The student repays the loan over three years. The amount of simple interest paid is:

Rs. 3,240=18,000×0.06×3

and the total amount paid is:

Rs. 21240= 18000+3240

COMPOUND INTEREST

Compound interest accrues and is added to the accumulated interest of previous periods; it includes interest on interest, in other words. The formula for compound interest is:

Compound Interest=P×(1+r)t−P

Where:

P= Principal Amount

R= Annual Interest Rate

t= Number of years interest is paid

It is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods, and then minus the reduction in the principal for that year. With compound interest, borrowers must pay interest on the interest as well as the principal.

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