The interest rate on fixed deposits, whether provided by a financial institution, a government enterprise, or a private corporation, is calculated in two ways. The first is simple interest, and the second is compound interest.
Both are calculated on only the principal investment, but both differ in their consideration of the principal amount. This leads to a difference in the return amount received by the investor at the end of their investment tenure.
Keep reading to understand the critical differences between these two types of interest calculations.
- Simple interest is calculated on the initial principal amount for each period.
- Compound interest is calculated on the principal amount as well as on any interest that has been added to it, resulting in interest being earned on interest.
Simple interest is calculated using the formula SI = P × R × T, where:
P is the principal amount
R is the annual interest rate
T is the time period
Compound interest is calculated using the formula CI = P× (1 + R/n) ^ n×T − P, where:
P is the principal amount
R is the annual interest
n is the number of times interest is compounded per year
T is the time period
| Compound interest | Simple interest |
| It is the guaranteed interest return you earn on a fixed deposit, except, here, the interest earned keeps adding to your principal amount. This, essentially, changes or increases your total principal amount. For instance, suppose you create a cumulative fixed deposit of Rs. 10,000 for 3 years at 6%, compounded annually. The first year you will receive simple interest as per the formula, which is P (Principal) x R (Rate of Interest) x T (Time or Tenure) / 100. In this case, the first year’s interest return comes out to Rs. 600. Since you are not withdrawing this interest amount, it gets reinvested, thus increasing your principal amount to Rs. 10,600. So, the second year you earn a 6% ROI on Rs. 10,600. And, on and on, it goes till your tenure is up. However, instead of using the formula above, financial institutions use the following formula to calculate the entire compound interest at the very start of your FD. P {(1+ i/100) n – 1}, where, P = Principal, i = Rate of interest and n = number of years. | It is the interest you earn on a pre-fixed principal amount over a certain period of time. Here, the interest earned is not added to your original principal amount. For example, suppose you create a non-cumulative fixed deposit of Rs. 10,000 for 3 years at 6% with a monthly interest payout. As per the simple interest formula, which is P (Principal) x R (Rate of Interest) x T (Time or Tenure) / 100, you stand to earn10,000 x 6% x 3 = Rs. 600 in the first, second and third year. Since you withdrew the interest earned at monthly intervals, your original principal amount remains the same. However, this is only true for fixed deposits that offer monthly payouts. You can opt for quarterly or half-yearly payouts. Here, you will earn partial compound interest compared to FDs with monthly interest payouts. |
| Since the simple interest earned on the principal amount keeps getting added to the principal amount, the effective yield or the total rate of return, in this case, is relatively higher than simple interest. | The effective yield or the total rate of return, in this case, is relatively lower than compound interest. |
Simple interest example:
Suppose you invest Rs. 10,000 at a 5% annual interest rate for 3 years. Using the simple interest formula, the total amount after three years will be:
SI = P x R x T
SI = 10,000 x 5 x 3 = Rs. 11,500
Hence, interest earned = Rs. (11,500 - 10,000) = Rs. 1,500
Compound interest example:
Now, consider the same Rs. 10,000 investment at a 5% annual interest rate, but this time compounded annually for 3 years. Here, interest is calculated on the principal plus any accumulated interest. Using the compound interest formula, the interest earned after 3 years will be:
CI = P× (1 + R/n) ^ n×T − P
CI = 10,000 × (1 + 5%)^3 - 10,000 = Rs. 1,576.25
To calculate compound interest, use the formula CI = P× (1 + R/n) ^ n×T − P, where:
P is the principal amount
R is the annual interest
n is the number of times interest is compounded per year
T is the time period
The primary difference between simple and compound interest is how interest is calculated. Simple interest is calculated only on the principal amount throughout the investment period. In contrast, compound interest is calculated on the principal as well as on the interest earned.
SI is computed solely on the initial principal whereas CI is calculated on the principal and any accumulated interest, resulting in substantial growth.
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19 September 2024
5 mins read
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