The interest is typically calculated as a percentage of the loan amount (Principal) and added to the principal when the loan is repaid.
If you borrow money, the lender wants a return on the money you borrowed in the form of interest. Compound Interest and Simple interest are the two most common types of interest. If you understand the differences between these two financial interests, you will be able to make better financial decisions, save money and build your net worth over time.
- An interest rate is a fee that the borrower pays to the lender to use a loan. The two most common types of interest are simple interest and compound interest.
- The simple interest rate is the percentage of the loan amount paid over a set period. Interest rates are usually owed on personal loans, auto loans, and mortgages.
- When a compound interest rate is applied to a loan, the interest accumulated increases, and the borrower is responsible for paying the interest on the loan amount and the interest on the loan.
- If you invest or put money into a savings account, look into compound interest. With these accounts, you can earn a higher return on savings, money market, and certificate of deposit accounts.
Simple Interest & Compound Interest
It is important to keep in mind that there are two ways of calculating interest on loans. These are simple interest and compound interest. There is no difference between borrowing funds from a bank or an NBFC. There is always an interest charge attached. For this reason, the borrower needs to become familiar with the concept of simple and compound interest before making any decision.
Under simple interest, the interest payable is based on the borrowed amount. In the case of a term loan, interest is calculated on the amount borrowed from the beginning of the loan. Simple interest refers to the interest paid on a borrowed fund used during a set period. In essence, simple interest is a percentage of the amount that is borrowed that is charged to borrow the money.
On the other hand, compound interest is more complex and difficult to calculate than simple interest. When compound interest is used, depending on the power of compounding, the capital on which interest would be charged would also include the interest. It is important to realize that the capital borrowed increases every time interest is compounded. A compound interest rate can be calculated daily, monthly, quarterly, half-yearly, or annually. It should be noted that, with greater frequency, the interest rate would also increase.
Difference between Compound Interest and Simple interest
There are several differences between simple and compound interest, including the following:
- It is easier to calculate simple interest. To calculate compound interest, many factors need to be taken into account.
- The Principal amount is always the same in terms of simple interest. Since compound interest is calculated as a percentage of the principal plus the interest earned or accrued to date, principal of compound interest is different every accrual period.
- Keeping in mind that the interest rates and principal amounts are always the same with a simple interest loan, you will not be charged for outstanding interest when you pay off the loan.
- If you borrow money to purchase a car loan, the simple interest works in your favor because the cost of borrowing the money is the same with every payment. When investing or saving, compound interest is better since your money will grow faster.
Compound Interest and Simple interest differ mainly because simple interest is calculated based on an amount of principal. Many financial institutions even provide you the facility to avail personal loan without CIBIL or instant loan for low CIBIL score.
In contrast, compound interest is calculated based on the amount of principal and the interest compounded over time.