Well!! This is a terminology we have been studying since our school days. But, still at times we do face problems when this term comes into picture while taking any type of finance. Such as Personal Loan, Home Loan, Car Loan, etc.
Getting into the definition part of it.
As defined in Investopedia:
Its for sure, once we have read the above definition we have a fair idea what it means.
Now, just to put the above definition in a simpler term.
Depending on the money being taken from a bank or a finance company as a loan (be it personal loan, home loan, car loan, education loan,etc.). Rate of Interest will be charged for the total amount borrowed.
Let me explain it with a scenario:
Let us consider that I have taken a personal loan of say Rs 10,000/- for an example from any bank or a finance company.
And the said Rate of Interest being charged is of 11.15%. annually. Say, the loan tenure is said to be 2 years.
Note: Rate of Interest is generally calculated on a yearly basis. There are two types of interest that is calculated.
- Simple Interest
- Compound Interest
In the above said scenario for the loan amount Rs 10,000/-
If we say it to be a simple rate of interest that will be calculated. Then, total interest being paid at the end of 2 years would be Rs 2230/-
If we say it to be a compound interest that will be calculated. Then, total interest paid at the end of 2 years would be Rs 2354.32/-
The difference of Interest amount is seen because in simple interest the interest is being calculated only on the principal amount, your interest amount of first year is not added here to calculate the interest for the 2nd year. But, in case of compound interest it is being calculated not only on the principal amount but it is calculated on (principal amount + interest amount of first year).
Formula used to calculate Simple Rate of Interest and Compound Rate of Interest is:
(Source of formula: Investopedia)
Simple Rate of Interest = P (Principal) x I (Annual Rate of Interest) x N (Years)
Compound Rate of Interest = P (Principal) x [ ( 1 + I(Rate of Interest) N (Months) ) – 1 ]
DISCLAIMER: This article is only meant for general education purpose.