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Simple or Compound Interest Rate – Which Type of Interest Rate Does the Bank Use?

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Highlights

  • How Simple and Compound Interest Rates Affect your Loan & Deposits?
  • Read this post to know the same

Yes, the bank may use different types of interest rates over your deposits and loan amount. These include a simple and compound interest rate they use on your deposits and borrowed amounts. Depending on their choice of interest rate, your earnings on deposits and payments on loans can be impacted accordingly. Simple interest rate loans have lesser obligations for borrowers to fulfill compared to a compounding interest rate-based loan. Whereas, you tend to earn more when compound interest is applied to your deposits. So, read this post to know more about these interest rate types.

Simple Interest Rate

The formula for calculating the simple interest is: (P x R x T / 100) here, P is the principal loan or deposit amount, R is the interest rate and T is the investment or repayment period.

Compound Interest Rate

It can be of two types which are periodic and continuous compounding. The formula for calculating the interest is P {(1 + i/100)n – 1}, where P is the principal amount, i is the interest rate and n denotes the duration. To know how it will affect your Fixed Deposit interest, you can see the example.

Suppose, you have invested INR 1,00,000 for 5 years at a 5% interest rate. So, the compound interest earns you around INR 1,27,628. And, with the simple interest, you earn INR 25,000 interest on the deposit amount of INR 1,00,000.

From the above example, you can find out the difference between the compound and simple interest earnings on your Fixed Deposits, where simple interest rates offer benefits on your principal deposit only. And compound interest provides interest over your earned interest that increases your overall interest earnings.

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Effect of Interest Rate on your Loan!

Interest is the amount you need to pay for borrowing money from the bank, but how much you pay depends on the terms of your loan. Like deposits, the type of interest rate – simple or a compound interest – your repayment can vary. Take a closer look at the methods of calculating interest on your loan and see how they will affect your EMI payments.

Simple Interest

With a simple interest rate on your borrowed amount, the interest amount payable over the tenure remains low. And the formula to calculate simple interest for your borrowed amount is P x R x T/ 100. You are paying interest for the total borrowed amount, which makes it easy to calculate. For example, if you borrow INR 10,00,000 at 12% for 5 years, the total interest you pay for the loan would be INR 3,00,000.

Compound Interest

Look at the formula on which the compound interest is calculated.

A = P (1 + r/n)nt

  • In this formula, A is the total amount you will pay over the tenure
  • P is the principal amount
  • r is the interest rate
  • n is the number of times interest is compounded per year
  • nt is the number of times interest is compounded

If the interest of 12% is compounded to the loan amount of INR 10,00,000, the payable interest for 5 years would be INR 3,34,667. As you can see, you’ll pay more if interest is compounded than you would if you get the loan where the simple interest rate formula is used.

How Much Do My Loan Costs?

When you borrow a loan, you get a statement that discloses your borrowing costs. And also you’ll get your amortization schedule which will show the amount of principal and the amount of interest that comprise each payment, illustrating how the loan will be paid in full over the loan term. The EMI includes a portion of principal and interest payable every month till the time the loan is there. However, the amount payable towards principal and interest will vary every month.

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