Difference Between Simple and Compound Interest – Explained with Examples
Understanding the difference between simple interest and compound interest can have a big impact on your financial life. Whether you are borrowing money through a student loan or saving for the future, these two types of interest affect your final amount very differently. In this article, we explain both in simple terms with real-world examples.
What is Simple Interest?
Simple interest is the kind of interest that is calculated only on the original amount of money you invested or borrowed. It stays the same every year and does not grow over time. This type of interest is common in short-term personal or car loans.
The formula for simple interest is:
Simple Interest = (Principal × Rate × Time) ÷ 100
Here,
Principal is the original amount,
Rate is the yearly interest rate (in percentage), and
Time is the number of years.
For example, if you borrow ₹5,00,000 at 10% interest for 5 years, the simple interest will be:
(5,00,000 × 10 × 5) ÷ 100 = ₹2,50,000
So, the total amount you have to pay back after 5 years will be ₹5,00,000 + ₹2,50,000 = ₹7,50,000.
What is Compound Interest?
Compound interest is a smarter way to earn or charge interest. In this method, the interest is calculated not just on the original amount but also on the interest that is added over time. This means you earn or pay "interest on interest".
The formula for compound interest is:
Compound Interest = Principal × (1 + Rate ÷ (n × 100)) raised to the power of (n × Time), and then subtract the Principal from the result
Here,
Principal is the starting amount,
Rate is the annual interest rate,
n is how many times interest is added in a year (for example, yearly is 1, half-yearly is 2, etc.), and
Time is in years.
Using the same example of ₹5,00,000 at 10% for 5 years with interest compounded annually:
First calculate:
(1 + 10 ÷ 100) = 1.10
Then raise this to the power of 5, which is 1.10 × 1.10 × 1.10 × 1.10 × 1.10 = approximately 1.6105
Now multiply: 5,00,000 × 1.6105 = ₹8,05,255
So the compound interest is ₹8,05,255 - ₹5,00,000 = ₹3,05,255
As you can see, in compound interest, you pay ₹55,255 more than in simple interest for the same loan.
Real-Life Example 1: Student Loan
Let’s say you take a student loan of ₹5,00,000 at 10% annual interest for 5 years.
Using simple interest, your total repayment will be ₹7,50,000.
But with compound interest (compounded annually), your total repayment becomes ₹8,05,255.
This means compound interest increases your repayment amount by ₹55,255 over 5 years.
Real-Life Example 2: Saving for the Future
Now imagine you invest ₹1,00,000 in a savings plan that gives 8% interest per year for 10 years.
With simple interest, you earn:
(1,00,000 × 8 × 10) ÷ 100 = ₹80,000
Total amount after 10 years = ₹1,00,000 + ₹80,000 = ₹1,80,000
But with compound interest (compounded annually):
(1 + 8 ÷ 100) = 1.08
1.08 raised to the power of 10 = approximately 2.1589
Multiply: 1,00,000 × 2.1589 = ₹2,15,893
So compound interest earned = ₹2,15,893 - ₹1,00,000 = ₹1,15,893
This gives you ₹35,893 more than simple interest.
Simple vs Compound Interest at a Glance
Simple interest is calculated only on the principal, and the total interest stays the same each year. It grows in a straight line.
Compound interest is calculated on the principal plus interest earned so far. It grows faster because it builds on itself over time. This is why compound interest is ideal for long-term investments like fixed deposits, public provident funds (PPF), or mutual funds.
Why It Matters in Real Life
For borrowers, simple interest keeps things predictable and manageable. For savers and investors, compound interest is a powerful tool to grow wealth.
Let’s say you start saving ₹2,000 every month at a 10% annual return. If you start at age 25 and continue till age 55, your total value will be around ₹1 crore. But if you delay this by just 10 years and start at age 35, your total will be only about ₹37 lakhs. That’s the magic of compounding.
Best Use Cases
Simple interest is usually found in short-term loans like car loans or personal loans.
Compound interest is used in bank savings accounts, recurring deposits, fixed deposits, mutual funds, and retirement savings plans. Most people who build wealth over time do so with the help of compound interest.
Tools to Help You
You can use calculators to understand your exact numbers. Try these:
Conclusion
To summarise, simple interest is easy to understand and works for short-term needs. Compound interest, though slightly more complex, helps you earn or pay much more over time.
If you're investing, let compound interest work in your favour. If you're borrowing, try to understand the cost over time — especially if it's compounded. A little awareness today can save or earn you a lot of money tomorrow.
