Compound interest:

The interest is said to be compound, when the interest for any interest period is charged on principal amount plus the interest amount accrued in all the previous interest periods. Compound interest takes into account the effect of time value of money on both principal as well as on the accrued interest also.

The following example will explain the difference between the simple and the compound interest.

Example: 2

A person has taken a loan of amount of Rs.10,000 from a bank for a period of 5 years. Estimate the amount of money, the person will repay to the bank at the end of 5 years for the following cases;

a) Considering simple interest rate of 8% per year

b) Considering compound interest rate of 8% per year.

Solution:

a) Considering the simple interest @ 8% per year;

The interest for each year = Rs. 10,000 X 0.08 = Rs. 800

The interest for each is year is calculated only on the principal amount i.e. Rs.10,000. Thus the interest accumulated at the end of each year is constant i.e. Rs.800.

The year-by-year details about the interest accrued and amount owed at the end of each year are shown in Table1.1.

Table 1.1 Payment using simple interest

* The amount repaid to the bank at the end of year 5 (since the person has to repay at EOY 5).

The total amount owed at the end of each year using simple interest is graphically shown in Fig. 1.1.