Many students dislike mathematics, especially the concepts taught in higher classes, and often question its application in their lives. However, some math topics hold utmost importance in one’s life and can help make difficult tasks easier and eliminate the use of a calculator. Basic math literacy can also help you stand out and better understand certain terms in finance, business or banking.
One such concept is interest. Most people buy a credit card in their life or take a loan. Interest is defined as the cost of borrowing money or the reward for lending money. It’s paid by the borrower to the lender in addition to the principal amount which was borrowed. There are two types of interest Simple and Compound.
Many people are confused about the two interest types, and today we’re here to clear up your doubts. Dive in to learn about the difference between simple interest and compound interest.
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Difference Between Simple Interest and Compound Interest
First, we’ll begin with the basic and brief definitions and formulas of simple and compound interest.
Whenever you borrow money, you have to pay it back with interest, which is an extra amount calculated as a small percentage of the amount borrowed. This is the working model of banks and how they function.
There are two major types of interest: Simple and Compound
Simple Interest
This is the interest which is levied on the principal or the original amount of the money borrowed or loaned. It offers low returns and is constant in growth.
Formula
(P × T × R) ⁄ 100
Where,
P = Principal Amount
T = Time Period
R = Rate of Interest
Compound Interest
This is the interest levied on the principal amount, along with the accumulated interest of previous periods. It’s often called “interest on interest.” It results in higher returns and constant growth.
Formula
CI = P(1+r⁄n)nt − P
Where,
P = Principal Amount
t = Time Period
r = Rate of Interest (decimal value obtained by dividing rate by 100)
n = number of times the interest is compounded annually
If the principal is compounded annually, then n=1 and the formula becomes CI = P(1+r)t − P
Difference | ||
| Parameters | Simple Interest | Compound Interest |
| Definition | The interest levied on the borrowed amount | The interest levied on the principal as well as the interest |
| Formula | (P × T × R) ⁄ 100 | P(1+r⁄n)nt − P |
| Return Amount | Less returns than compound interest | Much higher returns than simple interest |
| Principal Amount | The principal amount remains same every year. | The principal amount keeps changing |
| Growth | Money growth is low but steady | Money growth is fast and higher |
Example:
Assume you borrowed a loan of ₹10,000 for 5 years at an interest of 7%. Both the simple and compound interest are charged annually. Calculate the final amount you’ll have to pay in both scenarios.
Answer:
P = 10,000
r = 7
t = 5
SI = (P × t × r) ⁄ 100
= (10,000 x 7 x 5)/ 100
= ₹3500
CI = P(1+r)t − P
= 10,000(1+7/100)5 - 10,000
= 10,000 (1.07)5 - 10,000
= 14025.517 - 10,000
= ₹4025.52
As such, CI is higher than SI, which is beneficial for the lender but disadvantageous for the borrower.
Applications of Simple and Compound Interest
- Both simple and compound interest have varying applications but CI is more prevalent than SI.
- Simple Interest is charged on car loans, consumer loans and short-term bank deposits.
- Compound Interest is used in most banking and financial applications including long-term loans, stocks, bonds and fixed deposits.
Bottomline
Now that you know the difference between Simple and Compound Interest, you won't face any problems while making financial transactions, calculating loan interests, and fixed deposits, analysing stock returns and repaying your loans. Keep reading Jagran Josh for more such insightful articles.
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