Simple & Compound Interest

A Comprehensive Overview
Understanding the Fundamentals of Financial Growth
The Foundation: What is Interest?
%

Definition
Interest is the fee paid by a borrower to a lender for the use of their
money over a specific period.

Core Concept
Think of it as the "rent" you pay for borrowing money or the "earnings"
you make for lending it.
 The Language of Interest

   
Principal (P) Rate (r) Time (n) Interest (I) Amount (A)
The original sum of The percentage at The duration for which The additional money The total sum of the
money borrowed or which interest is the money is earned or paid. Principal and the
invested. calculated on the borrowed or invested, Interest at the end of
principal, usually per expressed in periods. the period.
year.
 Simple Interest (SI): The Basics

 Consistent Calculation
Interest is always calculated on the original principal amount
Simple Interest Growth Over Time only.

 No Growth on Interest
Accumulated interest from previous periods is not added
back to the principal for future interest calculations.

 Linear Increase
Year 1 Year 2 Year 3
The total amount grows at a steady, constant rate year after
Principal Interest year.
 Calculating Simple Interest
 Formulas for Simple Interest:

Interest Earned (I)

I = (P × n × r)/100
P = Principal n = Time (years) r = Rate (%)

Total Amount (A)  Key Feature

Simple interest grows linearly
over time, creating a straight
A = P + I or A = P(1 + nr/100) line when graphed
Compound Interest (CI): The Power of Growth
Growth Comparison: Simple vs. Compound Interest

 Interest on Interest
Interest is added to the principal at the end of
each period, forming a new, larger principal for
the next period.

 Accelerating Growth
The principal amount grows with each period,
causing the interest earned in later periods to be
greater than in earlier ones. This creates an
effect of exponential growth.

Simple Interest (Linear) Compound Interest (Exponential)

 Calculating Compound Interest
 Formulas for Compound Interest:

Total Amount (A)

A = P(1 + r/100)n
P = Principal r = Rate (%) n = Time (years)

The Power of
Compound Interest (I) 
Compounding
Like a snowball rolling
I = A - I = P[(1 + r/100)n downhill, compound interest
or grows exponentially as
P - 1] interest earns interest over
time.
Simple vs. Compound Interest: A Visual Comparison
Case Study
₹100 Principal @ 10% p.a.

Investment Growth Over 3 Years

 Key Takeaway
The difference in returns grows larger
over time, highlighting the power of
compounding.

Simple Interest Compound Interest

Year 1: SI: ₹110 | CI: ₹110

Year 2: SI: ₹120 | CI: ₹121
Year 3: SI: ₹130 | CI: ₹133.10
 The Difference After 2 Years

 Simple Interest (SI)  Compound Interest (CI)

Year 1 Year 1
Interest is calculated on the original principal (P) Interest is the same as simple interest

Year 2 Year 2
Interest is calculated on the same original principal (P) again. The interest from Year 1 is added to the principal. Interest for
The interest amount is identical to the first year. Year 2 is then calculated on this new, larger principal (Principal
+ Year 1 Interest)

 The 2-Year Difference Explained

The difference between the total compound interest and total simple interest after two years is precisely the interest earned on the first
year's simple interest.

Difference = P (r/100)²
Where P is the principal and r is the rate of interest
 The Difference After 3 Years
The gap between compound and simple interest widens significantly due to compounding's snowball effect

 Simple Interest (SI)  Compound Interest (CI)

Year 3: Interest is still calculated only on the original principal (P). The Year 3: The principal for this year is the amount from the end of Year 2
interest amount is the same as in Year 1 and Year 2. (Original Principal + Year 1 Interest + Year 2 Interest). Interest is
calculated on this even larger amount.
Total SI: (Year 1 Interest) + (Year 2 Interest) + (Year 3 Interest)
Total CI: (Year 1 Interest) + (Year 2 Interest) + (Year 3 Interest)

 Example Comparison (P=₹100, r=10%)

Year Simple Interest Earned Compound Interest Earned Total SI Total CI Difference (CI - SI)

1 ₹10 ₹10 ₹10 ₹10 ₹0

2 ₹10 ₹11 ₹20 ₹21 ₹1

3 ₹10 ₹12.10 ₹30 ₹33.10 ₹3.10

Growth Comparison Over 3 Years

 Key Insight
The difference grows from ₹1 after two years to ₹3.10 after three
years because compound interest for Year 3 was calculated on
the accumulated amount of ₹121, not just the original ₹100.

CI - SI = P × (r/100)² × (3 + r/100)
Formula for difference after 3 years
 Compounding Frequency
Compounding Periods in One Year  Beyond Yearly
Compounding can occur more than once a year—semi-
annually (twice a year), quarterly (four times), or even more
 Annually 1 Period
frequently.

Semi-
 Annually 6 Months 6 Months
 Formula for Frequent Compounding

A = P(1 + r/(k × 100))^(k × n)

 Quarterly 3 Months 3 Months 3 Months 3 Months
k = number of compounding periods per year

 Nominal vs. Effective Rate

Nominal Rate Effective Rate

The stated annual interest rate The actual rate you earn
(r) annually after accounting for
compounding. It is higher than
the nominal rate when
compounding occurs more
than once a year.
 Present Value (PV): Money's Worth Today

 Core Question
What is the value today of a sum of
money that you will receive in the future?
Future

P X
Amount (X)
Discounting
Present Value (P)
PV = FV / (1 + r)n  Concept
Money available now is worth more than
the same amount in the future due to its
potential earning capacity. Present Value
calculates this current worth.
 Calculating Present Value
The Present Value (P) of a future amount (X) due after 'n' periods at a rate of 'r' is:

SI CI
Under Simple Interest Under Compound Interest

P = X/(1 + nr/100) P = X/(1 + r/100)n

Linear discounting where the time factor is simply Exponential discounting where the rate is
multiplied by the rate compounded over each period
 Repaying Loans in Equal Installments
Principle of Equivalence
A loan is fully repaid when the sum of the
present values of all installments equals the
original loan amount.

 The Logic

P X X X X Each installment (X) is a future payment. Its

Present Value must be calculated to determine
Installment 1 Installment 2 Installment
Installment
3 n its worth at the time the loan was taken.
Loan Amount

 The Equation
The sum of discounted installments equals the
original loan amount, creating a balanced
P = X/(1+r/100) + X/(1+r/100)² + … + X/(1+r/100)ⁿ
financial equation.