Many of us have encountered situations where we needed to borrow money from a bank, post office, or by borrowing money from a moneylender for a partic
Many of us have encountered situations where we needed to borrow money from a bank, post office, or by borrowing money from a moneylender for a particular period. In return for the amount borrowed, we must repay it plus some extra money paid to the lender for using his money. This extra amount of money is called interest. Compound interest and simple interest are the main types of interest. It is easy to find simple interests. It is possible to calculate compound interest using the formula for simple interest.
It is a straightforward method of calculating interest on money. In this method, interest always applies to the principal amount, and the same interest rate is applied to each year’s interest. The interest on an item is calculated using simple interest if, throughout the loan period, it depends on the original principal. To calculate simple interest, the borrower needs to know the amount lent, the interest rate, and the length of time it will cover. This leads to lower interest payments when compared to compound interest.
Real-life applications of simple interest:
- Loans for cars: The repayment of a car loan is monthly, which means that each month a portion of the loan goes toward paying the outstanding balance, while the balance part goes toward interest. With each month that passes, the remaining loan balance decreases, and thus, the interest due decreases as well.
For example, suppose you have bought a car with a loan amount of ₹500000. The loan rate of interest is 5%, and the loan repayment time is 5 years.
Now, using the simple interest formula, you can easily calculate the monthly EMI of it. Let us find the total interest of 5 years on the principal amount.
S.I.= P ×T×R / 100 ⇒ 500000× 5 ×5 / 100 = ₹125000
Now, the amount =₹500000+₹125000 =₹6,25,000
Thus, your EMI will be =₹6,25,000 / 12×5 =₹10,420
- Certificate of deposit: Certificates of Deposit (CDs) are investments in which a fixed amount of money will be paid out on a certain date. You cannot take your money out of a CD until that date arrives.
If you invested ₹200000 in 1 year at 3% interest yearly, the interest of 1 year is on the principal amount.
Now, the amount =₹200000+₹6000 = ₹206000
So, you will get ₹6000 extra at the year-end.
- Loans for consumers: It is common for department stores to offer appliances to their customers on a simple-interest basis for one year at most. For example, suppose you would like to purchase a refrigerator for ₹30000 but don’t have sufficient cash to purchase it. It’s a monthly installment loan for 12 months or one year at 8% simple interest. The department store is offering it.
Now, the amount =₹30000+₹2400=₹32400
So, you will pay ₹2400 extra at the end of the year.
It can be concluded that if you had 30000, you would pay a smaller amount each month as opposed to repaying a portion of it every month.
Currently, most banks charge higher interest rates on loans if they apply the compound interest formula because it allows them to charge their customers more, but this method is complicated to explain. In contrast, simple interest simplifies calculations. Simple interest is advantageous when a customer is seeking a loan for a short period, such as one month, two months, or six months.
Simple interest is used in many banking institutions now, as more and more people are taking loans today, due to the rising standard of living and ever-increasing expenses. To understand many more concepts like this, visit Cuemath, one of the best online websites for learning and understanding maths easily.