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Taking out a loan for a new bike or getting a new phone with an EMI -all these transactions have one thing in common: simple interest. It is a term that pops up often, yet it’s not always fully understood.
Curious how this all works? Dive into our blog to decode the ins & outs of simple interest and see how it impacts your financial path.
What is simple interest?
The tool is a method to calculate interest that’s quite straightforward. It only looks at the original amount, called the principal. It uses a fixed rate over a certain amount of time . As opposed to compound interest it doesn’t increase interest further. This makes it easy to understand.
The principal stays the same throughout the calculation, providing a clear view of the accumulated charge. This technique is commonly used in various day-to-day financial scenarios like loans. It’s a simple and effective way to manage interest calculations.
Understanding this basic concept can help you make better decisions. It breaks down complicated ideas into something digestible. Whether you’re borrowing funds or investing, knowing this calculation can give you a clearer picture of your financial dealings.
Also read: The role of compound interest to reach your financial goals
How to calculate simple interest?
To determine simple interest, you only need a few basic inputs. The key elements are the initial amount, the percentage rate, and the duration.
The simple interest formula is:
SI = (P * N * R) / 100
Where P is the initial sum, R is the annual percentage rate, and N represents the time period in years.
First, identify the starting amount. This is the original sum of money you are dealing with, either as a loan or investment. Next, figure out the annual percentage rate, which is the yearly percentage applied to the starting amount.
Then, decide the length of time for which the interest is to be computed. This is usually expressed in years, yet to be consistent, convert it to years if the time frame is expressed in months/days.
To get the interest, take the initial amount by the time period and the percentage rate. Divide by 100 at the end.
To find the total amount at the end of the period, including the earned or paid interest, use:
Future Value (FV) = P + SI
Or, more compactly:
FV = P * (1 + (N * R) / 100)
This simple interest rate formula will give you the total sum you earn or owe after the specified time.
These steps help you understand how your money will grow or what you will need to repay. It’s a simple yet effective tool for financial planning.
You may also like: The pros and cons of investing in floating-rate fixed deposits
The types
There are two main variations involved: ordinary and exact. Though the formula remains the same, the way time is measured differs.
- Ordinary method utilises a 360-day period for its calculations. This approach simplifies the process, making it quicker and easier. It’s often used in basic financial computations.
- Exact method counts the actual number of days, whether it’s 365 or 366 for leap years. This method offers more precision, reflecting the true duration more accurately.
For example, suppose Ravi borrows ₹40k on 1st May and agrees to repay it on 15th July at an annual rate of 6%.
Using the ordinary method, calculate the days from 1st May to 15th July, which is 75 days. Convert this period into a fraction of 360:
Ordinary calculation = (40,000 * 6% * 75/360) = ₹500
For the exact method, use the actual 365 days:
Exact calculation = (40,000 * 6% * 75/365) = ₹493.15
As seen, the calculation type impacts the total amount. The ordinary method is simpler but less precise, while the exact method provides more accurate results.
Also read: What Type of Interest Rates Are Better on Business Loans?
The difference between simple interest and compound interest
Recognising the difference between the types has a substantial influence on financial choices. Here’s a clear comparison of the two:
| Parameters | Simple Interest | Compound Interest |
| Basis | Original sum only | Initial amount plus accumulated interest |
| Calculation | SI = (PNR) / 100 | CI = P(1 + r/n)^(nt) – P |
| Growth Pattern | Linear increase | Exponential growth |
| Frequency | One-time calculation on principal | Repeated calculation on growing amount |
| Usage | Car loans, short-term loans | Savings accounts, investments |
| Returns | Lower over time | Higher due to reinvestment of interest |
| Predictability | Predictable, steady payments | Variable, depends on compounding frequency |
| Suitable for | Borrowers needing fixed repayment plans | Investors seeking significant growth over time |
In the compound interest’s formula:
P is your starting amount.
r shows how much you earn yearly.
n tells how often you add the interest back in a year.
t is the total number of years you invest.
Bottomline
Grasping simple interest helps you understand your finances. It’s easy to figure out and use. Perfect for loans and basic savings.
It is imperative that one understands both simple interest and compound interest, particularly, if you are entering the world of investing for the first time. This knowledge empowers you to make smart financial choices. Maximise your returns and manage your money wisely.
FAQs
The formula is simple: SI = (P * N * R) / 100. P is the starting amount. R is the yearly interest rate. N is the time in years. Multiply these together. Then divide by 100. That gives you the interest earned. So, if you have ₹10k @ 5% for 2 years, it works like this: (10000 * 5 * 2) / 100 = ₹1000.
The first is when you earn interest on the original amount you saved or borrowed. It’s straightforward. The latter is when you earn interest on both the original amount and the interest that has already been added. This makes your money grow faster. Simple is easier to calculate. Compound gives you more money over time. Both are important to understand for managing your finances.
Start with these three values: P, R, and N. P is the initial amount of money. R is the annual rate. N is the duration in years. Use the formula SI = (P × R × N) / 100. So, multiply these values and then divide by 100. Suppose ₹5000 at 6% for 3 years, you get ₹900 after calculation.
For a ₹1 lakh mobile, you buy through EMI with simple interest. Each month, you pay a fixed interest amount. It’s straightforward and predictable. For the compound counterpart, think of a fixed deposit. You deposit ₹50k. The bank adds interest to your balance regularly. Over time, you earn interest on your initial deposit and on the interest already added. Your money grows faster. Simple is for fixed payments. Compound is for growing savings.
Simple interest rates are percentages that banks or lenders charge on the original loan amount. They don’t change over time. The rate is applied to the principal, and you pay the same interest every period. It’s easy to calculate and understand. This type of rate is common for car loans and personal loans.