Simple versus compound interest — and which one your product actually uses
Lenders quote whichever is more flattering. Knowing which convention applies tells you what a deposit really earns and what a loan really costs.
Two interest conventions exist, they diverge enormously over time, and which one applies to a given product is frequently not stated on the page quoting the rate.
The two formulas
Simple interest — charged only on the original principal:
SI = P × r × tCompound interest — charged on principal plus accumulated interest:
A = P × (1 + r)^tThe divergence
₹1,00,000 at 10%:
| Years | Simple | Compound | Gap |
|---|---|---|---|
| 1 | ₹1,10,000 | ₹1,10,000 | ₹0 |
| 5 | ₹1,50,000 | ₹1,61,051 | ₹11,051 |
| 10 | ₹2,00,000 | ₹2,59,374 | ₹59,374 |
| 20 | ₹3,00,000 | ₹6,72,750 | ₹3,72,750 |
| 30 | ₹4,00,000 | ₹17,44,940 | ₹13,44,940 |
Identical for one period. Wildly different by year 30. Simple interest is linear; compound is exponential, and exponentials eventually make linear functions look flat.
Which convention applies where
Compound, in your favour: fixed deposits, PPF, EPF, most mutual funds, savings accounts.
Compound, against you: credit card balances, most overdrafts.
Simple: car loans quoted on a flat basis, some personal loans, and the interest component on many short-term instruments.
The confusing case: home loans. An EMI-based home loan is technically simple interest applied to a reducing balance each month. Because the balance falls slowly, the effect on total interest is closer to compound than the "simple interest" label suggests.
The flat rate trap
This is where the distinction costs the most money.
A ₹5,00,000 car loan quoted at "8% flat" over 5 years charges 8% of ₹5,00,000 every year, all five years — including the final year when you owe almost nothing.
Total interest: ₹2,00,000. The equivalent reducing balance rate is roughly 14.5%.
The rough conversion: a flat rate is about 1.8 to 1.9 times the equivalent reducing rate on a loan of three to five years. Any quote that does not specify the convention should be assumed to be the one that flatters the lender.
Compare both
The one question to ask
For any loan: "What is the total amount I will repay?" For any deposit: "What is the maturity value?"
Both are single numbers that cannot be presented misleadingly. Every quoting convention becomes irrelevant once you have them.
Open the simple interest calculator
Where these figures come from
- Reserve Bank of India — Policy rates, lending and deposit regulation, credit card rules
Published by FinClamp. This guide is information, not financial advice — see the disclaimer.