 # What is the rule for compound interest?

Around 41% of personal loan applicants consider interest rate the primary factor when choosing a lender (1). Knowing the amount of interest payable and ways to minimize such costs helps streamline the repayment process. Moreover, borrowers must distinguish between the two types of interest, namely, simple and compound interest.

While most loan products in India follow the simple interest calculation method, other financial products rely on the compound interest rate formula.

## Understanding the definition of compound interest

In a compound interest method, the interest amount is added to the principal sum. During subsequent interest calculations, this new figure is considered the principal. Consider the following example to acquire a better understanding of how compound interest works.

Suppose an individual avails a loan of Rs.1 lakh for 5 years at a compounding interest of 10% per annum. After the first year, it would incur interest of Rs.10,000. Therefore, his new loan principal would be Rs.1 lakh + Rs.10,000 or Rs.1.10 lakh in the second year. The borrower’s interest calculation for that particular year would be conducted on Rs.1.10 lakh and not Rs.1 lakh.

Under a simple interest calculation method, the principal amount would remain unchanged at Rs.1 lakh for the entire 5-year duration. Borrowers are liable to bear decreased interest costs on loans in this case. Thus, the type of interest is a major factor affecting the personal loan interest rate.

## Formula for calculating compound interest

the compound interest rate formula remains unchanged, whether one is computing liabilities for a personal loan or returns from an investment product. It is as follows –

A = P (1 + r/n) ^ nt

Where,

• A = Total amount payable
• P = Principal sum
• r = Annual interest rate
• t = Tenor or number of years
• n = Compounding frequency (number of times in a year that interest is compounded)

Compound interest = A – P

The following example should clarify the process of calculation further –

An individual avails a personal loan of Rs.15 lakh for 3 years at 12% interest, compounded annually. In such a case, the various factors for calculation are as follows –

• P = Rs.15,00,000
• r = 12%
• t =  3 years
• n = 1

Placing each in the above formula, an individual gets –

A = 15,00,000 (1 + 12/1) ^ 1×3

A = Rs.21,46,153

Compound interest = Rs.21,46,153 – Rs.15,00,000 = Rs.6,46,153

Dividing the total amount by 36 months reveals that such a borrower would need to pay Rs.59,615 as EMI to repay his/her dues.

On the other hand, a similar loan on simple interest would cost significantly less to borrowers. In such a case, the interest burden would be limited to just Rs.2,93,573. Similarly, the EMI would be just Rs.49,821. Therefore, one of the ways to get the best personal loan rates is to apply for simple interest options only.

Individuals looking to secure the best rates on their loans can adopt other practices or methods as well.

Compound interest on loans can complicate repayment, forcing one to bear increased EMIs. However, a range of other factors also plays a role in determining interest charges. The borrower’s eligibility aside, even macroeconomic factors, such as repo rate, can determine how much one pays as interest on their personal loan.

### Tips to minimize interest cost on loans

After acquiring a deep understanding of how simple and compound interest methods work, borrowers must utilize other ways to lower their interest burden. Previous post What Does Power Outage Mean? Next post How to Find the Best Flooring Options for Gyms