Simple interest is a basic financial concept where interest is calculated only on the initial principal amount. It remains constant over time and is not reinvested. Unlike compound interest, which involves interest being charged not only on the original loan amount but also on the accumulated interest over time, simple interest is solely based on the initial principal amount. This means that each period's interest remains constant throughout the loan term, leading to a linear growth of the interest amount.
Simple interest formula
The formula to calculate simple interest is quite straightforward:
Simple interest (SI) = (principal amount) x (interest rate) x (time in years)
Where:
- Principal amount is the initial amount borrowed.
- Interest rate is the annual interest rate as a decimal.
- Time is the duration of the loan in years.
For example, if you borrow Rs. 50,000 at a simple interest rate of 5% for 2 years, the calculation would be as follows:
Simple interest (SI) = Rs. 50,000 x 0.05 x 2 = Rs. 5,000
In this case, the total interest you would pay over the two-year loan period would be Rs. 5,000.
Simple interest vs. compound interest
The primary distinction between simple interest and compound interest lies in the way interest is computed and accumulated.
1. Computation
Simple interest: The interest is calculated only on the original principal amount throughout the loan tenure.
Compound interest: The interest is calculated on the principal amount and any previously accrued interest. As time progresses, the interest amount keeps increasing, resulting in a higher overall interest cost.
2. Impact on total interest paid
Simple interest: Since the interest amount remains constant throughout the loan term, the total interest paid is relatively lower than compound interest for the same principal amount and period.
Compound interest: As the interest is compounded at regular intervals, the total interest paid is higher compared to simple interest for the same loan amount and duration.
3. Loan repayment
Simple interest: Monthly payments towards a loan with simple interest consist of both the principal and a fixed interest amount. As time passes, the interest portion decreases, and the principal repayment portion increases.
Compound interest: In a compound interest scenario, the interest amount increases over time, resulting in a higher interest portion in the monthly payments initially. As the loan term progresses, the principal repayment portion becomes more significant.
Simple interest calculation with an example
Suppose you borrow Rs. 1 lakh at a simple interest rate of 8% for 3 years.Using the simple interest formula:
Simple interest (SI) = Rs. 1,00,000 x 0.08 x 3 = Rs. 24,000
The total amount to be repaid at the end of three years would be Rs. 1 lakh (principal) + Rs. 24,000 (simple interest) = Rs. 1,24,000.
If you are planning on taking a personal loan, the interest calculation on your borrowed sum may not be as straightforward as simple interest. Therefore, we advise you to calculate your EMI estimates using a personal loan EMI calculator. All you have to do is enter the loan amount, tenure, and interest rate to get an accurate calculation.
