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Introduction

Principal, amount, simple interest, compound interest and rate of interests are the terms mostly used by banks or the money lenders who lends money to money borrower. Bank gives interest on the amount deposited by a customer. On the other hand, money lender charges interests on the amount borrowed by money borrower.

How does a bank give interest?

Bank keeps customer’s money in the savings or deposit accounts. Bank keeps on adding more money by themselves on top of what a customer had deposited at the begining.

How much extra money bank adds on to customer’s amount depends upon how much and how long customer keeps money in the bank. More a customer deposits, more the bank adds on into customer’s account and more time a customer keeps money in the bank, more extra money bank adds on.

So, let’s understand it briefly in terms of the basic terms of principal, interest, rate of interest and time period.

  1. Money that a customer deposits while opening a new bank account is called as the principal.
  2. Time for which a customer keeps money in bank is called as time period.
  3. Bank adds extra amount of money into customer’s account in addition to the principal amount, is called as interest.
  4. Bank gives interest after a specific period of time, which is called as rate of interest. Rate of interest is written in percentage figures only.

How does a money lender charge interest?

Money lender is the one who gives money to money borrowers. Money borrowers are the people who lends money from money lenders, which is the other way around. Money borrower returns back the borrowed money plus the interest to money lender. So borrower returned back more than the borrowed money.

Let’s dive in and understand the above terms in more detail with examples.

Principal

Amount of money deposited by a customer into the bank or amount of money borrowed by a borrower from money lender is called as principal. It is also called as a sum.

Example

Example 1
A customer deposits an amount of 100 $ in the bank.
So, 100 $ is the principal.


Example 2
Money borrower borrows an amount of 200 $ from money lender.
So, 200 $ is the principal.

Interest

Amount of extra money paid by borrower to the lender, in addition to what was borrowed is called as interest.

Example

Example 1
Bank adds 20 $ to customer’s deposited amount of 100 $.
So, 20 $ is the interest given by the bank to the customer.


Example 2
Money borrower gives back to money lender an extra 40 $ in addition to the borrowed 200 $.
So, 40 $ is the interest paid by money borrower to the money lender.

Amount

The total amount of money paid by borrower to the lender at the end of a specific period of time is called amount.
It is calculated with the following formula:

Formula

Amount = Principal + Interest

Example

Example 1
Bank gives interest of 20 $ on customer’s deposited principal amount of 100 $.
Amount = Principal + Interest
∴, Amount = 100 + 20 = 120
So, amount in customer’s account after receiving the interest = 120 $.


Example 2
Money borrower gives back to money lender an extra 40 $ in addition to the borrowed 200 $.
Amount = Principal + Interest
∴, Amount = 200 + 40 = 240
So, amount of money returned back by borrower = 240 $.

Simple interest

If interest is calculated uniformly on original amount of money throughout the specific period of time, this type of interest is called as simple interest.
It is calculated with the following formula:

Formula

Simple interest = Principal × Rate of interest × Time 100
or SI = P × R × T 100

Example

Example 1
A sum of $1000 is lent for 2 years at the rate of 5% per annum. Find the simple interest.
Principal = 1000
Rate of interest = 5% per annum
Time = 2 years
SI = P × R × T 100
= 1000 × 5 × 2 100
= 100 $


Example 2
Find the amount paid by a farmer if he borrows Rs 24000 for the time of 4 years at the rate of 6% per annum.
Principal = 24000
Rate of interest = 6%
Time = 4 years
SI = P × R × T 100
= 24000 × 6 × 4 100
= 576
Amount = Principal + Interest
Amount = 24000 + 576
= 24576 $

Compound interest

It is the interest calculated on principal value plus the interest on the new principal amount.
In other words, we can say that interest earned on the amount of previous period of time.
It is the interest which is earned on the principal plus previously accumulated interest.
It is calculated as:

Formula

Compound interest = Amount – Principal
CI = A – P

Amount can be calculated as:
A = P ( 1 + R 100 ) n
where, P = Principal, R = Rate of interest and n = Number of years

Example


Calculate compound interest on Rs 6000 for 3 years at 2% per annum. Method 1
P = 6000
R = 2% per annum
T = 3 years
As we know, A = P ( 1 + R 100 ) n
A = 6000 ( 1 + 2 100 ) 3
A = 6000 ( 100 + 2 100 ) 3
A = 6000 ( 102 100 ) 3
A = 6367.248
CI = 6367.248 – 6000
CI = 367.248


Method 2
P1 = Principal for first year = Rs 6000
T = 1 year
R = 2% per annum
Interest at the end of first year = 6000 × 2 × 1 100 = 120
Amount at the end of first year = 6000 + 120 = 6120
P2 = Principal for second year = Rs 6120
T = 1 year
R = 2% per annum
Interest at the end of second year = 6120 × 2 × 1 100 = 1234 10 = 122.4
Amount at the end of second year = 6120 + 122.4 = 6242.4
P3 Principal for third year = Rs 6242.4
T = 1 year
R = 2% per annum
Interest at the end of third year = = 6242.4 × 2 × 1 100 = 124.48
= 124.48
Amount at the end of third year = 6242.4 + 124.848 = 6367.248
Compound interest = Final amount – Original principal
=6367.248 – 6000
=367.248
In the above example, we can also find compound interest by adding interest of consecutive year.
CI = interest of Ist year + interest of 2nd year+ interest of 3rd year
= 120 + 122.4 + 124.848
= 367.248

Difference between compound and simple interest

In simple interest, principal value remains same for the whole period. Whereas, in compound interest, principal value remains changing with time and it remains not same for the whole period.
Compound interest keeps on increasing every year, whereas simple interest remains constant for every year.
Also, in compound interest, the principal value increases with time period which make the interest increases accordingly.

If the values of principal, rate of interest and time period are kept same to calculate simple interest and compound interest, the calculated value of compound interest is always found greater than simple interest. Let’s use an example to find out how compound interest is always greater than simple interest for the above case.

Example

Calculate simple interest and compound interest for $3000 at 4% per year in 3 years.

Simple interest calculations
Principal = 3000
Rate of interest = 4%
Time period = 3 years
Simple interest = = P × R × T 100
= 300 × 4 × 3 100
= 36000 100
=360
Compound interest calculations
A = P ( 1 + R 100 ) n
= 3000 ( 1 + 4 100 ) 3
= 3000 ( 100 + 4 100 ) 3
= 3000 ( 104 100 ) 3
= 3000 × 104 100 × 104 100 × 104 100
= 421824 125
Compound interest = amount – principal
= 3374.592 -3000
= 374.592
To understand this concept more briefly, lets have a look at the following tables with year wise calculations.

Table: Year wise simple interest calculations

PrincipalRate
of
interest
TimeSimple
interest
Amount
First year300041 year1203000 + 120
= 3120
Second year300041 year1203000 + 120
= 3120
Third year300041 year1203000 + 120
= 3120
Total360

Table: Year wise compound interest calculations

PrincipalRate
of
interest
TimeSimple
interest
Amount
First year300041 year1203000 + 120
= 3120
Second year312041 year124.83120 + 124.8
= 3244.8
Third year3244.841 year129.7923244.8 + 129.792
= 3374.592
Total374.592

Difference between simple interest and compound interest
Simple interest for 3 years = 120 + 120 + 120 = 360
Compound interest for 3 years = 120 + 124.8 + 129.792 = 374.592
Difference between them = 374.592 – 360 = 14.592