Simple interest and compound interest – these are the two methods of calculating interest charged on the business loan taken. Well, no matter whether you borrow funds from a bank or NBFC, the interest charge is always attached. So, it is important for the borrower to get well acquainted with the simple and compound interest in order to make a sound decision. In this blog, we shall discuss the difference between simple interest and compound interest and how to calculate them.
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What is Simple Interest?
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In simple interest, the interest is calculated on the amount loaned. The interest is calculated on the amount which is originally borrowed throughout the loan tenure. So, in simple words, simple interest is the sum paid for using the borrowed fund for a fixed tenure.
Simple interest is essentially the percentage of the actual loan amount charged for borrowing money. Suppose, you availed a business loan of INR 1,00,000 for a time period of 1 year. The business loan interest rate is 10%. So, the interest charged on it would be INR 7,000. Simple interest is easy and quick to calculate!
What is Compound Interest?
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Compound interest is comparatively a bit complex than simple interest. In compound interest, the capital on which the interest would be charged includes the interest as well, depending on the power of compounding. Basically, the capital borrowed increases every time the interest is compounded. It can be compounded daily, monthly, quarterly, half-yearly, or annually. Notably, with more frequency, the interest accrued would also increase.
To understand this better, let’s take the help of an example. Suppose, you borrowed INR 1,00,000 at the rate of 10% (compounded annually) for 2 years. The interest accrued would be INR 10,000. And with that, your new capital for the second year would be 1,10,000. So, the interest for the second year would be 11,000. A total compound interest that you would pay on INR 1,00,000 at the end of 2 years will be INR 21,000.
Said that, it is important to consider the number of compounding periods. If the frequency of compounding increases from a year to half-yearly or quarterly, the interest would also increase. A change in it can make a huge difference to the accrued interest.
What is the Formula for Simple Interest?
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The simple interest formula is:
P*r*n
Where
P = Principal
r = Rate of interest
n = Repayment tenure
Now, let us calculate interest using simple interest formula. Let the Principal be INR 2,00,000, the rate of interest is 10%, and repayment tenure is 3 years. Using the formula (2,00,000*10%*3), the simple interest equals to 60,000.
The amount payable at the end of the tenure will be INR 2,60,000. Here, the interest accrued for all the three years is 20,000 which equals 60,000 (20,000*3).
What is the Formula for Compound Interest?
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The compound interest formula is:
P*(1+r)^n
Where
P = Principal
r = Rate of interest
n = Repayment tenure
Now, let us understand this with the help of an example. Let us take the same example as above – the Principal be INR 2,00,000, the rate of interest is 10%, and repayment tenure is 3 years. Let the interest be compounded annually.
Using the formula {2,00,000*(1+10%)^2}, the compound interest equals to 66,200. According to this interest calculation formula, the compound interest for all the years is different – 20,000 for the first year, 22,000 for the second year, and 24,200 for the third year.
What is the Difference between Simple and Compound Interest?
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And now that you know how to calculate compound interest and simple interest, you can go ahead and make your choice for an SME loan. Notably, simple interest and compound interest have their own pros and cons but it is clearly evident that simple interest is low. So, if you want to choose one between simple interest and compound interest, simple interest certainly is the best option.
ZipLoan is an RBI registered NBFC that offers business loan with interest rate on the reducing amount. The interest rate that we charge on the borrowed amount is on the reduced amount and thus, you can save a significant amount of money which you otherwise would pay on interest. Also, our business loan interest rates are competitive in the marketing and we offer loans at minimal documentation.
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