How does Power of Compounding work: Simple vs Compound Interest
- December 8, 2021
- Posted by: MvM Team
- Category: Loans
Simple Interest
Simple interest is an interest on principal, where the borrower pays interest on the principal amount only. This remains constant throughout the tenure of the loan.
Simple interest = Principal × Interest Rate × Time.
Compound Interest
Compound interest or interest on interest is calculated on accumulated value of principal amount and accrued interest. It changes throughout the tenure of the loan.
Compound Interest = Principal × (1 + Interest rate) t – Principal
where t = Total number of years of loan;
Let’s take an example:
Seema and Rekha each take personal loan of ₹10,00,000 at interest rate of 10% p.a. for 5 years. Seema is charged simple interest whereas Rekha is charged compound interest (compounded annually).
Seema’s calculation:
Simple Interest (SI)
Principal Loan Amount | ₹10,00,000 |
Interest Rate | 10% |
Loan Period (in years) | 5 |
Total Interest in 5 years | ₹10,00,000*10%*5 = ₹5,00,000 |
Total Amount Paid | ₹15,00,000.00 |
Rekha’s calculation:
Compound Interest (CI)
Principal Loan Amount | ₹10,00,000 |
Interest Rate | 10% |
Loan Period (in years) | 5 |
Total Interest in 5 years | ₹10,00,000 [(1.105)-1] = ₹6,10,510 |
Total Amount Paid | ₹16,10,510 |
It can be seen from the above 2 tables that the Total Interest paid by Seema is less than that of Rekha by ₹1,10,510 over the total loan period of 5 years.
Compounding helps us to build a large sum of money when invested over a long period of time as we not only earn return on our invested amount (principal) but also accumulate return on return or interest on interest as explained in the above example.
