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While booking a fixed deposit or applying for a personal loan, you might have come across the terms simple interest and compound interest.
Both these terms denote ways of calculating interest on a lump sum amount over time and are subject to an interest rate decided by your bank or NBFC.
Simple interest, as the name suggests, is the simplest way of calculating interest on a fixed deposit.
This method does not add any interest rate on the newly accrued interest amount gathered on the principal amount.
In this article, we will discuss how simple interest works, what is the formula to calculate simple interest, what is the simple interest rate, and what is principal in simple interest.
What is the rate of simple interest? A simple interest rate is the rate of interest you earn on the amount you deposit in your bank. If you apply for a loan, the simple interest rate decides the amount you will pay back to your lender.
How this rate is applied while calculating the amount will become clear in the next section, “What is the formula to calculate simple interest.”
The formula for calculating simple interest is:
SI = (P x r x t) ÷ 100
SI = Simple interest
P = Principal amount, i.e., the amount you deposit in an FD or borrow from your lender
r = Rate of interest. This value is decided as per the terms and conditions of your lender or your bank
t = Term of the loan or fixed deposit in years.
If you are entering the tenure in months, then you will need to divide the value of t by 12. Then, the formula will be:
SI = (P x r x t) ÷ (100 x 12)
Once you have the value of simple interest, you can calculate the total amount. Depending on the context, this can be the maturity value of a deposit or the total amount payable at the end of the loan tenure.
Amount = P+ SI
Amount = P + (Prt/100) = P x (1+rt/100)
Now that you know what is principal in simple interest and what is simple interest rate let us look at a few examples of how this interest calculation comes into play.
The concept of simple interest is used in two cases:
When you open a fixed deposit with a bank, you allow them to hold your money for a period of time. While the bank has your money, they pay you interest on this amount.
When you take a loan, you promise your lender to pay the amount back with interest. This interest is calculated based on the simple interest rate and the loan tenure.
Suppose you invest Rs.50,000 in a fixed deposit account for a period of 2 years at an interest rate of 8%. Let us assume that your bank offers simple interest on this fixed deposit scheme.
As per the simple interest definition, the principal amount for the second year will not take into account the interest earned.
Then the simple interest you will earn should be calculated as follows:
(50,000 x 8 x 2) ÷ 100 = Rs. 8,000
The interest you will receive after 2 years will be Rs. 8,000. Therefore, the maturity amount of this fixed deposit will be Rs. 58,000.
Now, suppose this rate was higher, say 16%. Using the same formula, the interest comes out to be Rs. 16,000. Thus, the higher your interest rate, the higher your returns will be. This is why it is best to invest in a fixed deposit scheme that offers higher interest rates.
But what happens in case you borrow money? In that situation, it is best to aim for the lowest interest rate possible. Let us see how this works in the case of loans.
Let us say you borrowed Rs. 5 lakh as a personal loan from a lender on simple interest. Suppose the interest rate is fixed at 18% and the loan tenure is 3 years. Let us use the same formula to calculate the interest you will end up paying:
(5,00,000 x 18 x 3) ÷ 100 = Rs.2,70,000
The interest you will be paying over the period of 3 years will be Rs.2.7 lakh. Therefore, the total repayment you will make to the bank will be the following:
Amount = Principal + interest = Rs.7.7 lakh.
If you are paying this amount in monthly installments, then
EMI value = Amount/12= Rs. 21,390.
As per the simple interest definition, this method of calculation does not add the interest earned every year to the principal amount. On the other hand, compound interest is calculated by adding the interest earned to the amount each year, which then becomes the new principal amount for further calculations.
So, if you borrow money with simple interest, you will have to make smaller repayments. And if you opt for a fixed deposit scheme with compound interest, you will earn much higher returns.
Simple interest is one way to calculate interest over a fixed amount over time. The rate of interest remains constant throughout, and the principal amount remains unchanged. To calculate simple interest, use the formula given above or use a quick, simple interest calculator.
Most lenders in India use the compound interest method for determining your interest payable. The lower the interest rates, the easier it will be to repay your loan.
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