When you invest, you may want to earn as much interest as possible on your savings and pay less interest when you borrow. One of the biggest factors that affect the interest is whether you are accruing simple interest or compound interest. Read on to know more about it.

When you invest your money in any scheme or when you borrow a loan, you know you are obliged to earn or pay the interest, right? But how does this exactly work? The interest is a fee the financial institutions pay to the investors to compensate them for using their deposits. Similarly, the financial organisations levy an interest on the amount they lend to the people. Charging and paying interest is one of the ways financial organisations encourage people to make deposits and it is also a way for them to make money from the borrowers.

The interest amount is usually calculated based on the principal amount and it can either be a simple interest or compound interest.

What is simple Interest?

The simple interest rate is calculated by multiplying the principal amount by the rate of interest and the number of payment periods. The mathematical formula for calculating simple interest is as follows

Simple Interest = P x I x N

In the above formula,

  • P is the principal amount (the money you deposit or borrow)
  • I is the interest rate (applied by the financial organisation)
  • N is the duration (in years)

What is compound interest?

The compound interest refers to the charges that you must pay not on the principal amount but also on the interest accumulated at that point in time. In simple words, in compound interest, the interest is charged on the principal amount as well as the interest accrued in the previous year.

The interest added to the principal amount forms the new base on which the next round of interest is calculated. The compound interest can accrue daily, monthly or on a quarterly basis.

The mathematical formula for calculating compound interest is as follows –

A = P×(1 + r/n)nt

In the above formula,

  • A is the final amount including the interest
  • P is the principal amount
  • R is the annual interest rate
  • N is the number of compound per year
  • T is the actual loan tenure

While you can calculate the simple and compound interest manually, there is always a risk of human errors. And this can sometimes put off your interest calculation and your financial planning. Hence, to avoid making any mistakes, it is advisable to use the online simple interest calculator or the power of compounding calculator.

These are online tools that allow you to compute the interest applicable on your loan within a few seconds. These calculators are easy to use, and you can easily operate them even if you don’t have any prior experience or technical expertise. You must simply enter the details like principal amount, interest rate, tenure, etc and the calculator will give you the results instantly.

How to know what type of interest is applied?

If you are not sure what type of interest rate is applied to your deposit or loan, you must check the investment or loan related documents or contact the financial institution. Typically, in case of credit card payments, compound interest is applied, whereas in case of student loan borrowed from a nationalised bank simple interest will be applied. Similarly, if you have invested in bank fixed deposits, you are eligible to receive simple interest payment, whereas, if you have interest NPs (National Pension System), you get compound interest payment.

Simple Interest or Compound Interest – Which is Better

If the interest rate and the loan duration is the same, the compound interest will eventually be higher than the simple interest. If you are earning compounding interest then it is better, but if you are paying, simple interest is ideal.