Simple Interest vs Compound Interest - Key Differences
Simple Interest (SI) is calculated only on the original principal for every period. The interest earned each year stays constant and does not earn further interest. Compound Interest (CI), on the other hand, calculates interest on both the principal and the accumulated interest from prior periods - causing the amount to grow exponentially.
For borrowers, CI means you pay more than SI for the same loan. For investors, CI means your savings grow faster over time. This is why financial experts say: "Understand compound interest - earn it, don't pay it."
Simple Interest Formula
A = P × (1 + R × T)
SI = P × R × T
P = Principal amount
R = Annual interest rate ÷ 100
T = Time in years
Compound Interest Formula
A = P × (1 + R/n)^(n × T)
CI = A – P
P = Principal amount
R = Annual interest rate ÷ 100
n = Compounding frequency per year
(Yearly=1, Half-Yearly=2, Quarterly=4, Monthly=12)
T = Time in years
The Rule of 72
The Rule of 72 is a quick mental shortcut to estimate how long it takes an investment to double at compound interest. Simply divide 72 by the annual interest rate:
Doubling Time ≈ 72 ÷ Annual Rate (%)
At 6% → doubles in ~12 years
At 9% → doubles in ~8 years
At 12% → doubles in ~6 years
At 18% → doubles in ~4 years
This rule works because ln(2) ≈ 0.693 and 72 is a close approximation that divides neatly by many common interest rates.
Where SI and CI are Used in India
Simple Interest is used in short-term personal loans, some gold loans, certain government schemes, and vehicle loans where flat-rate interest is quoted. Many fintech lenders and NBFC personal loan products use SI with a flat rate - making them appear cheap but effectively costlier than reducing-balance CI loans.
Compound Interest is used in bank FDs, recurring deposits, savings accounts, home loans (reducing-balance = CI applied monthly), credit cards (dangerous monthly compounding at 2–3%/month!), and all investment products like mutual funds, PPF, and NSC. PPF compounds annually, bank FDs quarterly, and savings accounts daily.
Compounding Frequency Matters
The more frequently interest compounds, the higher the effective yield. At 10% annual rate: yearly compounding gives ₹1,61,051 on ₹1L over 5 years; quarterly gives ₹1,63,862; monthly gives ₹1,64,531; daily gives ₹1,64,872. The differences seem small early on but become significant over decades.
Frequently Asked Questions
Is compound interest always better than simple interest?
For investors, yes - CI always yields more than or equal to SI for the same principal, rate, and duration. For borrowers, CI means you pay more. The difference becomes dramatic over long periods. For a ₹1L principal at 10% for 20 years: SI gives ₹2L (₹1L interest), while CI (quarterly) gives ₹7.24L (₹6.24L interest) - more than 6× more interest.
Do bank FDs use simple or compound interest?
Bank Fixed Deposits in India use compound interest, typically compounded quarterly. When you see an FD offering 7% per annum, the actual effective annual yield (after quarterly compounding) is slightly higher - about 7.19%. For cumulative FDs, interest compounds every quarter. For non-cumulative FDs, interest is paid out periodically without compounding.
What is the effective annual rate (EAR)?
EAR (also called Effective Annual Yield) accounts for the effect of compounding within a year. It is always higher than the nominal rate unless compounding is annual. Formula: EAR = (1 + r/n)^n – 1, where r = nominal rate and n = compounding periods per year. At 12% nominal compounded monthly, EAR = (1 + 0.01)^12 – 1 = 12.68%.
How does compounding work on credit cards?
Credit cards in India typically charge 2%–3.5% per month on outstanding balances - effectively 26%–42% per annum with monthly compounding. If you carry a ₹50,000 balance for 12 months at 3%/month, you owe over ₹71,000 - nearly ₹21,000 in interest alone. This is why paying only the minimum due is financially dangerous.
What is the difference between nominal rate and effective rate?
The nominal rate is the stated annual interest rate without considering compounding. The effective rate (EAR) reflects actual growth after compounding. A 12% nominal rate compounded monthly has an effective rate of 12.68%. Banks are required by RBI to disclose both for loan products under the MCLR framework to help borrowers make accurate comparisons.
