Interest plays a pivotal role in the world of finance, shaping how your investments grow. The choice between simple interest and compound interest can significantly influence the returns on your savings. Let's delve into the world of interest and explore the key differences between simple and compound interest.
What is simple interest?
Simple interest is the most straightforward form of interest. It is calculated only on the principal amount, or the initial sum of money lent or invested, without considering any previously earned interest. This type of interest is commonly used for short-term loans or investments.
Simple interest formula
The formula for calculating simple interest is:
Simple Interest = (P × R × T)/100
where:
- P = principal, which is the original sum of money.
- R = rate, which is the interest rate per period.
- T = time, which is the length of time for which the money is borrowed or invested.
What is compound interest?
Compound interest, on the other hand, is the interest on the principal amount plus any interest earned to date. This means that over time, you earn interest not just on your initial investment but also on the interest accumulated over previous periods.
Compound interest formula
The formula for compound interest is more complex than that for simple interest and can be expressed as:
Compound Interest = P (1 + r/n)nt- P
where:
- P = principal, which is the original sum of money.
- r = rate of interest (decimal obtained by dividing rate by 100).
- n = the number of times the interest is compounded annually (if quarterly, then 4; if monthly, then 12).
- t = time, which is the overall tenure.
What is the power of compounding?
The power of compounding is often referred to as the "eighth wonder of the world" for its ability to exponentially increase the value of an investment over time. It works on the principle of earning interest on your interest in addition to earning interest on the principal amount. This means that with each compounding period, the base amount on which interest is calculated grows, leading to potentially significant growth over the long term.
Example:
Let's consider an example to illustrate the power of compounding. Imagine you invest ₹10,000 at an annual interest rate of 5%, compounded annually. Here’s how your investment grows over 10 years:
| Year |
Principal at Start |
Interest for the Year |
Total at Year-End |
| 1 |
₹10,000 |
₹500 |
₹10,500 |
| 2 |
₹10,500 |
₹525 |
₹11,025 |
| 3 |
₹11,025 |
₹551.25 |
₹11,576.25 |
| 4 |
₹11,576.25 |
₹578.81 |
₹12,155.06 |
| 5 |
₹12,155.06 |
₹607.75 |
₹12,762.81 |
| 6 |
₹12,762.81 |
₹638.14 |
₹13,400.95 |
| 7 |
₹13,400.95 |
₹670.05 |
₹14,071.00 |
| 8 |
₹14,071.00 |
₹703.55 |
₹14,774.55 |
| 9 |
₹14,774.55 |
₹738.73 |
₹15,513.28 |
| 10 |
₹15,513.28 |
₹775.66 |
₹16,288.94 |
As shown in the table, the initial investment of ₹10,000 grows to ₹16,288.94 over 10 years. The key takeaway here is that not only did the principal amount earn interest, but the interest earned in earlier years also earned interest in subsequent years. This compounding effect results in a growth curve that accelerates over time, especially as the compounding frequency increases (e.g., semi-annually, quarterly, or monthly).
The difference between compound interest and simple interest
Interest levied
Simple interest is levied on the principal alone, whereas compound interest is levied on the principal amount along with previously accrued interest.
Growth
Compound interest results in exponential growth due to the interest-on-interest effect, unlike the linear growth seen with simple interest.
Returns
The returns on compound interest are generally higher over time compared to simple interest, assuming the same interest rate and investment period.
Principal amount
The principal amount remains the cornerstone for calculating both types of interest, but its impact is magnified with compound interest due to the compounding effect.
Also Read:What is MCLR (Marginal Cost of Funds-based Lending Rate) in banking?
Bottomline
When considering where to park your savings, understanding interest types is key. Simple interest, calculated on the initial sum alone, provides predictable, linear growth. In contrast, compound interest, applied not only to the original amount but also to the accumulated interest over time, can significantly boost your earnings, harnessing the power of growth upon growth.
Axis Bank Fixed Deposits offer a safe and flexible way to earn compound interest on your savings. With the ease of starting an FD with a minimum investment of ₹5,000 and the convenience of managing it online, you can enjoy the benefits of compounding that may lead to a more substantial sum over the investment's tenure.
FAQs
What is the difference between compound interest (CI) and simple interest (SI)?
The difference between CI and SI lies in their calculation; CI includes interest on the interest earned, while SI is calculated only on the principal.
What is the principal in simple interest?
In simple interest calculations, the principal is the initial amount of the investment. It's the baseline figure on which the interest is calculated.
Why is compound interest used?
Compound interest is employed in long-term investments due to its ability to grow wealth at an accelerated rate over time. Investors use it to benefit from the effects of reinvesting interest, as it leads to exponentially increasing the investment's value, particularly in cases like retirement accounts, where compounding can occur over several decades.
Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
