What Is Interest Rate? Simple Interest vs. Compound Interest Explained with ₹1000 Example
Understanding how interest rates work is one of the most important steps in mastering personal finance. Whether you are saving money or taking a loan, interest directly affects how much you earn or pay.
This article will help you understand:
- What is interest rate
- The difference between Simple Interest and Compound Interest
- Easy ₹1000 examples to help you understand better
What Is Interest Rate?
An interest rate is the percentage of the principal amount that a lender charges a borrower (or a bank pays to the account holder) for using money over a certain time period.
👉 Formula:
Interest = Principal amount × Rate × Time / 100
- Principal = Initial amount (e.g., ₹1000)
- Rate = Interest rate per year (%)
- Time = Number of years
Table of Contents
What Is Simple Interest?
Simple Interest (SI) is the extra money earned or paid only on the original amount, called the principal, not on any interest added later. It does not change every year.
📌 Formula:
SI = (P × R × T) / 100
💰 Example:
Suppose you deposit ₹1000 in a bank at 5% annual interest for 3 years.
SI = (1000 × 5 × 3) / 100 = ₹150
So after 3 years, you’ll have:
₹1000 (principal) + ₹150 (interest) = ₹1150
✅ Simple and predictable.
❌ No growth on past interest earned.
What Is Compound Interest?
Compound Interest (CI) is calculated on the original amount (principal) plus the interest that has already been added in earlier years. It grows faster because the interest “compounds” over time.
📌 Formula:
CI = P × (1 + R/100)^T – P
💰 Example:
Deposit ₹1000 at 5% compound interest for 3 years.
Let’s calculate year by year:
- Year 1: ₹1000 + 5% = ₹1050
- Year 2: ₹1050 + 5% = ₹1102.50
- Year 3: ₹1102.50 + 5% = ₹1157.63
So, total compound interest = ₹1157.63 – ₹1000 = ₹157.63
Compare with simple interest of ₹150, compound interest gave ₹7.63 extra in 3 years.
✅ Higher returns over time
✅ Works best for long-term savings
❌ Slightly complex to calculate manually
Simple Interest vs Compound Interest (Comparison Table)
| Feature | Simple Interest | Compound Interest |
|---|---|---|
| Calculated On | Principal only | Principal + accumulated interest |
| Returns | Lower | Higher over time |
| Complexity | Very simple | Slightly complex |
| Suitable For | Short-term deposits, small loans | Long-term savings & investments |
| Example (₹1000 @ 5%, 3 yrs) | ₹150 | ₹157.63 |
📌 When to Use Simple vs Compound Interest?
Use Simple Interest when:
- You need short-term loans
- You are calculating small-duration fixed deposits or RDs
- Predictability is more important than returns
Use Compound Interest when:
- You want long-term savings (FDs, mutual funds, PPF)
- You’re investing for wealth creation
- You want your money to grow faster through compounding
Key Takeaways
- Interest is what you earn or pay for using money.
- Simple Interest gives fixed, predictable returns.
- Compound Interest grows your money faster by reinvesting earned interest.
- Over time, compound interest can grow much faster than simple interest because it keeps adding interest on both the principal and the previously earned interest.
📝 Final Words
Understanding Simple Interest vs Compound Interest helps you make smarter financial choices—whether it’s saving, investing, or taking a loan.
Even a small deposit like ₹1000 can grow much more under compound interest if given time. So, start early and let your money work for you!