How do Banks Charge Interest?

By | October 19, 2019

Difference Between Simple Interest and Compound Interest –  Interest is the amount of interest paid on the money borrowed by a person. Interest can be charged in two ways-

  • Such an interest, which is charged only on the loaned Amount, is called Simple Interest and
  • Such an interest, which is charged by adding Loan Amount + Accumulated Interest, is called Compound Interest .

Let us try to understand in a little detail about both these types of Interests, because the entire Banking System is based on both these types of Interests somewhere.

Simple Interest Definition

Simple Interest is that which is charged  as a predefined Percentage on the Principal Amount (Principal) for the entire Borrowing Period . This is the simplest method of calculating interest on Borrowed Amount, which leads to rapid calculation of interest. Car loan is the most common example of this type of interest because interest in car loan is charged only on the Principal Amount only borrowed.

The following Formula is used to calculate Simple Interest.Read also: You can save up to 1.5 lakh tax per year. how?

Simple Interest = P*R*N

Where as,

P = Principal Amount
R = Rate of Interest
N = Number of Years

Let us understand the Calculation of Simple Interest by an example. Suppose you have lent Rs 20,000 to your friend for 2 years, on which you will charge 15% Per Annum (annually) Simple Interest Charge, then after 2 years your friend will give you back the amount of interest in addition to the principal To find out, we can calculate Simple Interest using the above formula. where-

Principal Amount = 20000
Rate of Interest per Period = 15%
Number of Years = 2 Yrs.

Simple Interest = 20000 x 15/100 x 2
Simple Interest = 6000

That is, your friend will pay a total of 26000 rupees, of which 20000 rupees will be of Principal Amount and 6000 rupees will be of Simple Interest.

Interest Whether Simple or Compound, you say this is especially significant to keep in mind that you  Interest Rate are thought to how that is your friend if you pay interest Annually  once (a year) , Half Yearly (twice a year ) , Quarterly (four times a year) , Monthly per month ) , Weekly (per week)  or Daily (per day) on the basis of how much interest will be paid on the basis of which circumstances.

For example, suppose you will take 15% interest annually from your friend but your friend will pay interest on Half Yearly Basis i.e. twice a year. In that case his Half Yearly Interest Rate will be 7.5% only.Read also:

As a result, if in the above example, although your friend borrows money from you for a maximum period of two years, but for some reason his need is fulfilled and he wants to repay your loan within 6 months, then in that case his interest Calculation will be on 6 months basis and interest rate will be half ie 7.5% only. As a result, your friend will only repayment you only 21500 rupees, because a yearly interest of Rs 3000 is made according to 15% Annually Interest Rate, then the interest Amount for 6 months will be 1500 rupees.

Relationship in Rate of Interest and Time

When we give money in the form of loan to someone, in return we take some Extra Amount from it in the form of Interest. This Extra Amount means that the rate at which interest is calculated has a special relation to the time period as we discussed in the previous section.

For example, when we deposit our savings in a Saving Account of a bank, we are actually giving a loan to the bank, on which the bank usually gives us an interest at 4% per annum, but the bank gives us this interest, Half Yearly returns on the Basis, so every 6 months on our Deposited Total Amount in Saving Account actually calculates interest at the rate of 2%.Read also: How to do Financial Planning so that there is no spreading of hands.

Compound Interest Definition

Compound Interest is  an interest that is charged on the sum of Revised Principal Amount ie Original Principal Amount + Accumulated Interest (Accumulated Interest) of earlier periods .

Under this method,  the interest received on the Initial Principal ( Initial Principal ) is added to the Initial Principal Amount , and the next time the Calculation of Interest is done, this time not on the Principal but the Principal as the Principal Amount. Is used. In simplest terms, Compound Interest (compound interest) is also known as interest on interest .

For example, the bank gives us compound interest every 6 months at the rate of 4% per annum on the Deposited Total Amount in our Saving Bank Accoun t. So basically the bank pays us a compound interest at the rate of 2% on our Total Deposited Amount every 6 months. Let us try to understand the Calculation of Compound Interest by an example where we are assuming that we have 10,000 rupees Deposited in Saving A / c, on which the Bank would give us interest every 6 months at the rate of 4% per annum. is. In this situation-Read also: Post Office Time Deposit – What is Post Office Time Deposit Scheme?

Interest on first half = 10000 x 2/100 x 1 (half year)
Simple Interest = 200

Since this Rs 200 accrued interest is also deposited by the bank again in Saving A / c, which becomes the principal again, so now the principal actually becomes Rs 10200 instead of Rs 10,000. As a result, when the bank calculates interest again after 6 months, then-

Interest on second half = 10200 x 2/100 x 1 (half year)
Simple Interest = 204

That is, the annual interest paid by the bank on a half-yearly basis at the rate of 4% on the amount of 10000 will be 200 + 204 = Rs 404 . Whereas if the bank would have given simple interest instead of compounding, then in that case the total Accumulated Simple Interest = 10000 x 2/100 x 2 (half year) = 400 rupees only because Accumulated Interest is not considered as a share of principal in Simple Interest i.e. Interest is not paid on interest.

Manually calculating the compound interest is quite complicated, so generally the following formulas are used to calculate it.

Compound Interest = P(1+R/N)^NT – P

Where as,

P = Principal Amount
N = Number of Compounding Per Year
T = Number of Years
R = Rate of Interest Per Period

Now if we calculate the Bank Interest of our previous example by this formula, then-

P = Principal Amount = 10000
N = Number of Compounding Per Year = 2 (Half Year)
T = Number of Years = 1
R = Rate of Interest Per Period = 4% Yearly

Compound Interest = 10000 x (1 + 4/100 x 2)^2 x 1 – 10000
Compound Interest = 404

You can understand that even after applying interest at the same rate (Principal Amount) at the same rate (Compound Interest), Compound Interest is 4 rupees more than Simple Interest, because compound interest gets interest on interest, and that’s it There is also the biggest feature of this interest, which is also called the world’s strange wonder because who knows the power of compound interest, no one can stop him from becoming rich.

What is the power of compounding?

Let us try to understand it a little better by an example.

Suppose you have deposited your 10,000 rupees in a scheme, where you will get compound interest every 6 months at an annually interest rate of 10%, then-

Principal Amount = 10,000/-
Interest Rate = 10% Annually
Number of Years = 10 Yrs.
Number of Compounding Per Year = 2 or Half Yearly Basis

Compound Interest = P(1+R/N)^NT

Compound Interest = 16,532.98

Due to compound interest, after 10 years you will get a total interest of Rs 16532.98. But if only Simple Interest was received on this Amount for the same amount of time, then-

Principal Amount = 10,000
Rate of Interest per Period = 10% Annually
Number of Years = 10 Yrs.

Simple Interest = 10,000 x 10/100 x 10
Simple Interest = 10,000

Because of Simple Interest, after 10 years you will get a total interest of Rs 10,000. That is, just by changing the way of calculating interest, you will lose Rs 16532.98 – 10000 = 6532.98 and this is happening because when Compound Interest Calculate, every time interest calculates, along with that interest, by adding to the fund Increases. As a result, the next time the interest calculates, you also get interest on your previous interest and this is the power of compound interest.

But you get the benefit of compound interest only if you do not withdraw with interest every time you get Interest Amount. If every time you withdraw your Accumulated Interest Withdraw, then only your Principal Amount remains invested, as a result, despite the Compound Interest Scheme, that scheme actually remains a simple interest scheme for you.

Since the entire power of Compound Interest is hidden in the fact that Accumulate Interest increases the Actual Principle by adding to the principal again, resulting in a higher rate of interest next time despite having the same interest rate. So how soon your Invested Amount will actually become higher depends entirely on the fact that  what is the Conversion Period of your Interest Calculation .

Two Interest Payment Period  (interest payment period) between Time Interval  (interval) the Conversion Period  is known as the (transition period). Interest Compound is done at the end of the conversion period as follows.

Conversion PeriodCompounded
1 DayDaily
1 WeekWeekly
1 MonthMonthly
3 MonthsQuarterly
6 MonthsSemi-annually
12 MonthsAnnually

The shorter the conversion period, the sooner your Accumulated Interest is converted into Principal Amount. Therefore Compound Interest based on 1/365% Daily will be much higher as compared to 1% per annum because your Principal Amount will increase everyday in 1/365% Daily as compared to 1% per annum, because Accumulated Interest everyday will be more than your previous. Will be added to the principal.

This table means that if you do Compound Interest Charge on Daily Basis, then your Initial Principal Amount will be Daily Change and if you do Weekly Compound Interest Charge, then your Initial Principal Amount Change will be done every Week. Similarly, if you have Monthly Basis, Monthly, Quarterly Basis, Quarterly, Half Yearly Basis, Half Yearly and Annually Basis, Annually your Initial Principal will be Amount Change.

Normally, banks pay interest on Half Yearly Basis, but in Financial Institution there is a policy of paying Quarterly Interest. So if you deposit 10000 rupees at 8% per annum in Bank FD , and your friend deposits 10000 rupees at 8% per annum in a LIQUID FUND Scheme , then the interest your friend gets, more than you It will be because the bank calculates interest on Half Yearly Basis while Mutual Fund Companies on Quarterly Basis.

When we talk about compound interest, then we must definitely know on what basis we have to pay interest daily, Weekly, Monthly, Quarterly, Half Yearly or Annually or when we will receive the payment of interest. , Because this Conversion Period has a tremendous impact on our Interest and the shorter the Calculation of Interest is done, the more the Interest Generate. But when we talk of Simple Interest, this Conversion Period does not matter on our Interest Amount, because the interest is always charged only on the Principal Amount.

In conclusion, it can be said that-

  • Interest is the fee that is paid at a predetermined fixed rate in exchange for the use of another’s money. There are many reasons for paying interest such as Time Value of Money , Inflation , Opportunity Cost and Risk Factor .
  • Calculation of Simple Interest can be done easily and easily because Principal Amount always remains the same whereas Calculation of Compound Interest is slightly Difficult as Principal Amount Change happens.
  • If you calculate Simple Interest and Compound Interest with same period, Amount and Interest Rate, then Compound Interest will always be more than Simple Interest due to its Compounding Effect .

Leave a Reply

Your email address will not be published. Required fields are marked *