simple interest loan vs compound interest loan
loans make it easier to get extra credit but you need to be extremely cautious of the cost of availing of such financial assistance. if you are planning to take a home loan or an auto loan, you would want to get a loan offer with an interest rate as low as possible. from the viewpoint of a borrower, you would want to keep your loan interest rate as low as possible to lower the overall cost of your house or car. there are two ways to calculate the loan interest - simple interest, and compound interest. let's try to understand the difference between simple interest and compound interest to figure out which type of loan is best for borrowers.
what is a simple interest loan?
the simple interest loan is calculated on the basis of the principal amount borrowed. the term interest indicates the amount of money you will need to pay to the lender above repayment of the principal sum. to calculate the simple interest, you can use the formula provided below:
simple interest = principal amount x rate of interest x loan tenure
so for example, if you decide to take a loan of 50,000 with a simple interest rate of 8 percent for one year, you will pay a total of 4,000 as interest and the overall payment amount would be 54,000.
what is a compound interest loan?
compound interest calculation is based on the principal amount plus the accumulated interest of the previous periods. so if you compare compound interest with simple interest, you would notice that you effectively pay interest on the interest when taking a compound interest loan. in the case of compound interest loans, the interest can compound either daily, monthly, quarterly, biannually, or once a year.
the compound interest can be calculated using the formula, a = p(1+r/n)nt, where a is the amount you have after compounding. p represents the principal balance, r is the interest rate, n is the number of times that interest compounds per year and t are the number of years.
the rate at which compound interest accrues depends on the frequency of compounding. the higher the number of compounding periods, the greater the compound interest. this is why, when you increase the loan tenure, the overall interest portion increases and vice-versa.
what’s the difference between simple interest and compound interest?
simple interest | compound interest |
|---|---|
simple interest is easier to calculate and easier to understand | manual calculation of compound interest is complex and time consuming |
in this case, the interest is accrued on the principal amount borrowed or invested | in this case, interest is accrued on the principal amount plus the accumulated interest of the previous periods |
very few simple interest loan products available in the market | most of the banks and NBFCs use compound interest formula for loan products |
overall repayment to the lender will be lower compared to compound interest | the overall interest paid on the financed amount will be higher due to compounding interest rate |
simple interest is not good for investing money | compound interest is better to grow funds at a faster rate |
the takeaway
understanding the different types of interest calculation formulas will help you find the right product when looking out for loan offers. with the above examples, you can understand the difference between simple and compound interest. this knowledge will come in handy when you are trying to choose the right loan.
from a borrower’s perspective, a simple interest loan is best to avoid being stuck with an expensive debt that may take years to pay off. but if you’re an investor looking to grow your funds or accumulate wealth for retirement, it’s best to find an investment tool in which the interest compounds frequently.
you can use the free online simple interest calculator by CRED to make the right financial decisions. CRED simple loan calculator is an easy tool where you just need to enter the principal amount, interest rate, and loan tenure. the CRED calculator will instantly display how much interest and overall repayment you would have to make towards the principal amount financed. you can rearrange the three variables - principal amount, interest rate, and tenure - to compare different loan offers.
use CRED simple loan calculator