The interest rate is one of the essential factors borrowers should check before availing of any loan. These rates have separate functions in terms of loans and investments. For investments, it denotes how much one can earn from income-generation schemes, while for loans, it says how much one is liable to pay against their loan.
Depending on the calculation method, two types of interest rates are applicable: simple interest and compound interest. These two rates provide different results when evaluated in similar situations. Therefore, individuals must have detailed knowledge about these rates and their significant difference.
What is the difference between simple and compound interest?
To understand the difference between simple and compound interest, individuals first need to know these two rates and how they function.
Simple interest applies directly to the principal amount. In other words, individuals can calculate this amount as a percentage of the total principal. In this case, the variable remains constant throughout.
On the other hand, compound interest is defined as the overall interest calculation on the revised principal that includes previously accumulated interest.
Borrowers must note that the total payable amount with the compound interest will be more than that of simple interest.
The calculation involves basic compound interest and simple interest formula. The mathematical formula of simple interest is –
Simple Interest (I) = (P x R x T)
Here, P refers to the principal, R is the interest rate, and T is the time period in years
Following is a detailed description of how simple interest is calculated with the help of an example.
Example- Rajiv avails a personal loan of Rs. 20,000 from a financial institution for one year. The applicable interest rate is 5% p.a. What will be the interest and the total amount Rajiv has to pay after one year?
Solution: Here, loan amount or principal = Rs. 20,000
Interest rate= 5%
Time = 1 year
The total calculation of interest rate after 1 year is
As already mentioned, SI = (P x R x T) / 100
= 20,000 x 0.05 x 1
= Rs. 1,000
Moreover, the additional amount to be paid after one year will be:
Amount = (Principal + Interest)
= Rs. (20,000 + 1,000)
= Rs. 21,000
Now, to calculate the compound interest, one needs to follow the following formula:
A = P x [{1 + (r/n)} nt– 1]
Here, P refers to the principal, I denote the annual interest rate, and N denotes the compounding period in years.
Let’s understand the calculation with a simple example
Example – Mr. Kishore invests Rs. 10,000 at 10% for five years. The overall calculation of compound interest as per formula would be –
Amount – 10,000* [(1+10%) ^ (5)- 1]
= Rs. 6,105
The key difference between simple interest and compound interest is the amount of interest one would pay throughout the entire loan tenor. Compound interest is preferred for investments, generating higher interest than SI. Thus, the above calculation of these two interest rates will give a clear idea to the borrowers about the impact on personal finances.
Individuals can understand this better by knowing how to use a personal calculator, which will determine the overall amount, EMI, and the total payable interest. However, the overall payable interest rate is affected by several factors.
Factors impacting personal loan rates
Here is a list of factors affecting personal loan interest rates:
- CIBIL score
A credit score is a significant determinant to assess a borrower’s creditworthiness. Lenders usually prefer a credit score of 750 or more for hassle-free loan approval. Borrowers with a higher credit score can avail affordable interest rates. However, borrowers need to know the ideal Cibil score for personal loans before applying.
- Debt-to income ratio
Before applying for a loan, borrowers must check their debt-income ratio and keep them as low as possible to avail quick loan approval. A lower percentage will allow individuals to ensure lower interest rates.
- Repayment history
Financiers prefer borrowers with zero defaults and a clean credit profile. However, if financial institutions offer a personal loan to the borrower with a history of default, they have to pay a higher interest rate.
Thus, the above essential pointers will allow borrowers to understand what measures they must adopt to avail better interest rates for a personal loan.
Besides affordable interest rates, individuals can ensure faster loan applications with pre-approved offers extended by leading financiers like Bajaj Finserv. These offers are available on a wide range of financing options, such as personal loans, business loans, credit cards, etc. Individuals can check their pre-approved offers online by mentioning their essential credentials.
Therefore, simple interest and compound interest are the most effective and traditional ways to calculate rates against any financial product. Nonetheless, before availing of any loan, one should be mindful about calculating these rates to make an informed decision.
Read Also: Know How You Can Calculate FOIR For a Personal Loan