What is a Simple Interest Rate and How to Calculate It, The concept of simple interest was brought by financial institutions as a way to determine the amount a person would get in the future on an existing amount and how much he has to repay against the borrowed amount. Since simple interest is easy to calculate and manage, most banks and financial institutions prefer to use the same. For example, a bank can easily make use of simple interest to determine how much a borrower needs to pay back against a loan amount. In the further part of this post, you will get to know more about simple interest, its definition, its calculation, and other relevant things.
Simple interest is largely considered as a way to measure the interest on a loan using a specific technique. This kind of calculation is done by multiplying the principal amount by the applicable interest rate for the said period (years). This is calculated by considering the number of days that have passed since the last payment date.
Any kind of change done to a loan taken on simple interest is primarily awarded to the principal amount that is still unpaid and the interest amount.
Simple Interest = (P x R x T)/100
In the above formula, P refers to principal, R means interest rate, and T means time or length.
Take a look at the following example for more clarification:
For example, just think that Sanjay has taken a personal loan of an amount of Rs. 1,00,000 at an annual interest rate of 10% from a bank for a year. At the end of the year, Amit's loan account would be in the following scenario:
Total Loan Amount Taken (P): Rs. 1,000,000
Applicable rate of interest (R) is 10%.
Time interval (T): 12 months
(P x R x T)/100 = (1,00,000*10*1)/100 = 10,000 would be the total simple interest Sanjay would pay to the bank.
Keeping this scenario in mind, Sanjay is known to owe Principal + Interest (1,000,000 + 10,000 = 1,10,000) after the first year.
There are two types of simple interests: simple and exact. However, it is interesting to know that both are calculated using the same technique. The amount of time used in each category is the only visible difference.
The exact simple interest takes into account the exact number of days in a year, which could be 365 or 366 in a leap year. On the other hand, in the case of general simple interest, 360 days are taken as the comparable number of days in a year.
Let's look at the following as an example to have a better understanding of it:
In this scenario, Sanjay borrowed Rs. 15,000 from a bank on June 1, 2020, with an assumption that he would pay it back on August 10, 2020, to expand his modest office. The ROI, or agreed-upon rate of interest, is 6%. The simple interest will be computed as follows in this scenario:
Rs. 15,000 refers to the principal amount.
Interest rate: 6%
Number of days between June 1 and August 10 is equal to 29 + 31 + 10 = 70.
Days in years: 70 days x 1/360 days = 7/36 years
Now, apply this equation = (P x R x T)/100
Interest comes to Rs. 175 (15,000 x 6% x 7/36).
As a result, Sanjay would have to shell out Rs. 175 as total interest.
Now by using the same formula, determine the precise method for calculating simple interest:
Total Amount: INR 15, 000
Duration: 70 / 365 years
The interest calculation will be as follows:
150 000 x 6% x 70 / 365 = 180 Rupees
Simple interest is quite easier to measure and decode in comparison to compound interest. There is no need to worry for a person about interest being added to the principal amount if your loan is for the short term or based on compound interest. For instance, simple interest is charged on a majority of vehicle loans and home loans.
Compound interest gets favored over simple interest for investment purposes since it allows a quicker appreciation of the money than it would in an account. When it comes to determining the yearly percentage return, compound interest is considered primarily. That is the annual cost of borrowing money or the annual rate of return.
A borrower is obliged to pay simple interest to obtain a loan for the said amount. When you make a payment, the principal—the amount you borrowed—is applied to the remaining funds after the interest is subtracted.
It would be easy for a borrower to calculate and pay simple interest if there were no late payments. As long as you pay your principal installments on time, you will eventually pay less interest. Late payments might result in higher interest rates for borrowers, which could lengthen the time it takes them to pay off the total loan.
Simple interest is used in the calculation of various long-term loans as well as short-term loans. For example, most consumer and vehicle loans are based on simple interest estimates.
Simple interest is the money you receive as an investor in exchange for extending a loan to an individual or organization for a predetermined amount of time. Your payment amount is based on the percentage that you and the borrower agreed upon. You will only be compensated in excess if the borrower makes late payments. It raises the possible interest rate for a particular loan.
This kind of interest may also be applicable to savings accounts maintained with financial institutions, as well as investment options for individuals or businesses. Certain certificates of deposits (CDs), which give the depositor a fixed sum of money over a certain period of time, employ simple interest. Simple interest is also taken into account in the computation as
Simple interest and compound interest tend to carry differences primarily in that the previous one simply pays interest on the principal value, while the latter lends interest on both the principal amount and accumulated interest from earlier periods.
Some of the most common applications that employ simple interest calculation are auto loans, FMCD loans, monthly amortization, etc.
Yes, both simple and compound interest are used in banks nowadays.