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.
What is simple interest?
Simple interest is a straightforward method of calculating interest on a principal amount over time. It is based only on the initial sum, known as the principal, and does not take into account any interest earned in previous periods. The interest is calculated as a percentage of the principal for each time period.
Simple interest formula
The formula to calculate simple interest is quite straightforward:
Simple interest (SI) = (principal amount) x (interest rate) x (time in years)
Or
Simple interest (SI) = P x R x T
To Calculate total amount, the formula will be:
A = P + S.I.
OR
A = P(1+RT)
Where,
A = Total Loan Amount to be Repaid
P = Principal amount
S.I. = Simple Interest
Calculation of Simple Interest With Example
In simple interest calculation principal amount would be fixed throughout the loan tenure.
For example, if you borrow Rs. 50,000 at a simple interest rate of 5% for 2 years, the calculation would be as follows:
Here, the lending amount P = Rs. 50,000
Interest rate over the loan tenure = 5%
Time of Lending Repayment T = 2 Years
Then the Simple interest will be calculated as,
Simple interest (SI) = Rs. 50,000 x 0.05 x 2 = Rs. 5,000
Therefore, the total loan amount to be repaid will be,
A = 50,000 + 5,000 = Rs. 55,000
Additional read: What is simple interest calculator?
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: 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.
Types of loans that are offered on simple interest
Below are the few types of loans that are provided on simple interest:
- Personal loans: Commonly offered with simple interest terms, used for various purposes.
- Auto loans: Financing for vehicle purchases, often with straightforward interest structures.
- Student loans: Assistance for education expenses, featuring simple interest in some cases.
- Business loans: Funding for businesses with simplified interest payment plans.
- Instalment loans: Payments consist of both principal and interest, simplifying repayment.
Why is simple interest important?
Simple interest is important because it provides a clear and easy method for calculating interest on loans, investments, or savings. It is widely used in financial transactions, allowing quick comprehension of interest accrual without complicating factors. Its simplicity facilitates transparency and aids in making informed decisions regarding borrowing, lending, or investing.
Types of loans are offered on simple interest
Several types of loans are offered with simple interest, where interest is calculated only on the principal amount. Personal loans, car loans, and student loans often use simple interest. This straightforward method eases calculation, ensuring borrowers pay interest solely on the original loan amount, simplifying repayment.
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.
