Simple vs. compound
interest

How simple interest works

Both methods answer the same question: how much extra do you earn on savings, or pay on a loan, for the use of money over time? What differs is the amount the interest is calculated on.

Simple interest is calculated only on the original amount, the principal. Every year adds exactly the same sum, so growth is a straight line.

For example, ₹50,000 at 6% for 3 years earns 50,000 × 0.06 × 3 = ₹9,000, for a total of ₹59,000. Convert months to years first: 18 months is 1.5 years, so the same deposit would earn ₹4,500 in 18 months.

How compound interest works

Compound interest is calculated on the principal plus the interest already added. Interest earns interest, so each period’s increase is larger than the last.

Both formulas assume one lump sum that is left alone. If you add money regularly, as with a recurring deposit or a SIP, each instalment grows for a different length of time, so you need a calculator built for that.

Seen year by year, it is easy to follow. ₹1,00,000 at 8% earns ₹8,000 in year one. In year two the interest is charged on ₹1,08,000, so it is ₹8,640 and the balance reaches ₹1,16,640. Simple interest would still add only ₹8,000.

A worked example

Put ₹1,00,000 away at 8% a year for 10 years. With simple interest you earn ₹1,00,000 × 0.08 × 10 = ₹80,000, ending with ₹1,80,000. With interest compounded yearly, the amount is ₹1,00,000 × 1.08¹⁰ = ₹2,15,892.

In year one the two are identical. After 20 years, compounding has produced ₹3,66,096 in interest against ₹1,60,000 for simple interest, more than double. The gap itself compounds: it grows from ₹35,892 at 10 years to ₹2,06,096 at 20, about 5.7 times larger, even though the time only doubled.

The rule of 72 gives a rough feel for the speed. Divide 72 by the annual rate to estimate the years needed to double money under compounding: at 8% that is 72 ÷ 8 = 9 years. With simple interest, doubling takes 100 ÷ 8 = 12.5 years.

Does compounding frequency matter?

Yes, but far less than time does. The more often interest is added, the slightly faster the balance grows. On ₹1,00,000 at 8% for 10 years:

Moving from yearly to monthly adds about ₹6,072, while the extra years in the first table add far more. When comparing products, look at how often interest is compounded as well as the headline rate.

A useful yardstick is the effective annual rate, the yearly-compounded rate that gives the same result. A nominal 8% compounded monthly works out to about 8.30% a year, quarterly about 8.24% and half-yearly 8.16%.

Where each is used

Which method applies depends on the product and its terms, so read the agreement.

• Savings and deposits: many bank deposits add interest at fixed intervals, such as quarterly, so they compound. Your deposit terms say how often.
• Loans: some short-term or informal loans quote simple interest. Many bank loans instead charge interest every month on the balance still owed, which is why the EMI guide uses a reducing-balance formula.
• Unpaid dues: on some credit products, interest on an unpaid balance is added period after period, so it behaves like compounding. Check the terms for how yours is calculated.
• Investments: market-linked returns are not a fixed rate, so the compound formula only illustrates growth if returns were steady.

When you compare two products, ask three questions: what is the rate, how often is interest added, and is it charged on the original amount or on the balance still owed? The answers decide which of the two formulas applies.