QA – Simple and Compound Interest Explained

When X borrows some money from Y, then X has to pay certain amount to Y for the use of this money. This amount paid by X is called interest.

Interest can be of two types:

1. Simple Interest

2. Compound Interest

Simple Interest (I) = (P * r * t)/10

(Where P is the principal or money deposited, r is the rate of interest, t is the duration for which the money is burrowed)

Do note that when compound interest is applicable, interest is earned not only on the original sum (the principal) but also on all interests earned previously. In other words, at the end of each year, the interest earned is added to the original amount and the money is reinvested.

Compound Interest can be calculated as follows: A = P [1+(r/100)]n

(Where A is the total amount, P is the principal, r the rate of interest and n is the duration or which the money is invested)

Important Notes:

Simple Interest: Simple interest is calculated only on the principal amount of a loan. Thus, irrespective of the year, interest will be calculated on the original amount deposited, i.e. the sum at the beginning of first year.

i) The principal remains the same every year.

ii) The interest for any year is the same as that for any other year.

Compound interest: Compound interest is calculated on the principal amount and also on the accumulated interest of previous periods and can thus be regarded as “interest on interest”

In other words, the amount at the end of first year (or period) will become the principal for the second year (or period); the amount at the end of second year (or period) becomes the principal for the third year (or period) and so on.

In case of Compound interest

i) The amount at the end of a year is the Principal for the next year.

ii) The interest for different years is not the same.