There are two types of interest the first one is the simple interest which is based on the principle amount of a loan or deposit. You get interested in the principal amount till its maturity. The other one is the Power of compounding interest rate which is based on the principle amount and the interest that is accumulated on it every period.
What is simple interest?
In simple words, simple interest is the cost of borrowing that an investor has to pay only on the principal amount. Investors get lots of benefits from this as they have to pay interest only on the principal amount. In the other words, the one who has taken a loan has to pay interest only on that principle amount for a fixed period.
The best part of simple interest is that it doesn’t consider the previous interest rate. It is just simply based on the principle amount. It is easily calculated by multiplying the principal amount by the interest rate for the period and tenure.
Simple interest can be calculated on car loans, home loans, certificates of deposits, savings, etc. It can be calculated on a daily, monthly, or yearly basis.
From the point of view of borrowers, simple interest benefits them as they have to pay interest only on the principal amount, not as interest on interest as compounding. While investors see themselves at a loss because they will not get interested in interest.
The formula for simple interest
Simple interest can simply be calculated by multiplying the principal amount by the interest rate for the period and tenure. The tenure can be in days, months, or years. Hence interest changes based on the period before multiplying with the principal amount and tenure.
Now just have a look at the formula,
Simple interest = P*I*N
P = Principle amount
I = Interest rate for the period
N = Tenure
Let’s, understand simple interests more clearly with an example: –
Suppose, you have taken a loan of $ 1, 00,000 from the bank for two years at a simple interest of 5%. Then you have to calculate the total amount as: –
S.I = P*I*N
= 1, 00,000*5/100*2
= $ 2, 10,000
Then you have to pay a total of $ 2, 10,000 to the bank.
What is compound interest?
Unlike the simple interest, the power of compound interest is a kind of interest that give interest on previous interest which adds to the principal amount. In the other words compound interest is interest on interest. The whole principle increases because of this interest as compared to the simple interest.
The principal amount can grow more return than the amount in simple interest from the investment. The interest amount can grow faster because this whole interest is based on compounding on interest. The interest frequency can be decided by the financial institution it can be daily, weekly, monthly, quarterly, or yearly. Power of compounding interest rate is more beneficial for the investor rather than the borrower because the borrower gets capital appreciation in interest and principal amount and on the other side borrower has to pay more.
The formula for compound interest
Compound interest can be simply calculated by multiplying one plus interest raised by the power of the compounding period by the principal amount raised by the power of the number of compounding periods multiply by the number of years minus one.
Compound interest (A) = P((1+r/n)^(n*t)-1)
A = Compound interest
P = Principle amount
r = the rate of interest
n = the number of compounding interest
t = numbers of years
Let’s understand compound interest with a clearer example: –
Suppose, you have invested $ 1000 in a mutual fund at the rate of 3% for 2 years.
C.I = P((1+r/n)^(n*t)-1)
Year1 : Interest earn = $ 30
Year2 : interest earn = $ 1030 (0.003)
= $ 1060.9
Total interest earn = 60.9