Simple and Compound Interest

Rate of Interest, Principal and Time

When we part with our money to keep it in the bank, the bank pays us an ‘interest’ to do so.
Similarly when we borrow money, we have to pay an ‘interest’. The interest received or paid
depends on three factors:
Principal (P): The amount of money that is loaned out or is borrowed is called the Principal.
Interest would obviously depend on the principal. Higher is the amount, more is the interest
and lower the amount, lesser is the interest.
Time Period (t): Again it should be obvious that if the money is loaned or borrowed for a longer
time period, more interest will be charged and for a shorter time period, lesser will be the
interest.
Rate of Interest (r): There is a third factor which determines the Interest. This is the Rate of
Interest, expressed as a percentage. This is a pre-determined amount that the giver and the
receiver agree to and it specifies the amount of interest charged per Rs. 100 of the principal for
a specified time period. Thus if the rate of interest agreed is 8% per annum, it means that on
every Rs. 100 of the principal amount, the interest will Rs. 8 per year.
Further, there are two ways in which an Interest can be charged. For each of the year the
money is borrowed/loaned, Interest could be charged just on the principal amount loaned/
borrowed (as done in Simple Interest) or for each of the year the interest could be charged on
the amount outstanding i.e. principal amount and the accrued interest of the previous years
(as done in Compound Interest). These two methods are discussed in details in the following
sections.

Simple Interest
In this method the interest charged per year is calculated only on the principal. What this
means is that if Rs. 1000 will be loaned/borrowed, the interest will be charged only on Rs.
1000 even in successive years.
Thus if the rate is r % per annum, then Simple Interest per year = r % of P and thus we get the
following formula for SI, which most of us are already acquainted with.
P ×r ×t
SI =
! 100

Amount returnable = Principal + SI

E.g. 1: If A deposits Rs. 20,000 in a bank for 3 years at a rate of 10%, what is the simple
interest he will get at the end of the period?
Here P = 20,000, r = 10%, t = 3 yrs
20,000 × 10 × 3
Hence SI = ! 100 = Rs. 6,000
E.g. 2: Sagar borrows Rs. 50,000 from a bank for 5 years. What is the rate of simple interest
charged by the bank if after 5 years Sagar had to pay Rs. 66,000 to the bank?
Here 66,000 is the total outstanding amount which is Principal + SI. Since principal is given as
Rs. 50,000, we get SI = 66,000 – 50,000 = Rs. 16,000
50,000 × r × 5 32
16,000 = ⇒r =
Using the above formula, ! 100 ! 5 = 6.4%

E.g. 3: After how many years would an amount double itself at 15% rate of interest?
We don’t have the principal here, we can denote it by P. If the amount doubles then obviously
the SI would be equal to the principal.
P × 15 × t 100
P= ⇒t =
So we have ! 100 15 = 6.667 years

E.g. 4: The rate of interest of a bank is 10%. Akash was taking a loan of a huge amount for one
year so the bank agreed to give him the loan at a rate of 8%. They reasoned that even with 8%
they will get twice the interest that they would have got had they given out a loan of Rs.
40,00,000 at 10% for a year. What is the amount of Akash’s loan?
If P is the loan taken by Akash, writing the realtion comparing the two simple interests,
P × 8 ×1 40,00,000 × 10 × 1
= 2× ⇒
! 100 100 P = 1,00,00,000

Exercise
1. Ajay takes a loan of Rs. 30,000 from a bank for 8 years at 6.5% rate of simple interest. He then
loans out Rs. 20,000 for 8 years at 7.5% rate of simple interest. He could loan out the balance only
at 5.5% for 8 years. In the entire transaction, did Ajay make or lose money and how much?
1. gain 400 2. gain 800 3. No gain, No loss 4. loss 400 5. loss
800
2. Vijay took part of Rs. 10,000 loan at 4% and the rest at 6%. If he pays a total interest of Rs. 900
in two years, find the amount taken on loan at 4%. The interest rate charged by the bank is Simple
Interest.
1. Rs 8000 2. Rs 7500 3. Rs 7000 4. Rs 6000 5. Rs 5000
3. The underworld don Chhota Pappu loans money to people at simple interest. He charges a
certain rate of interest for the first year. Next year he doubles the initial rate of interest on the
amount. Third year he triples the initial rate of interest and so on… A man took an amount of Rs.
9000 and after 3 yrs paid back an amount of Rs. 15000 back. What was the rate of interest in the
first year?
1. 9% 2. 9.09% 3. 10% 4. 11.11% 5. 12.5%
4. I needed Rs. 1,20,000 to buy a Plasma TV and hence I borrowed Rs. 75,000 from Vani and the
rest from Vivek. Vani and Vivek charge me a rate of interest such that the interest amount payable
to both of them is the same. If in all I re-pay them a total of Rs. 1,50,000 at the end of 2 years, what
is the rate of interest charged per annum by the two?
1. 10%,20% 2. 12.5%, 20% 3. 10%,16.66% 4. 12.5%, 16.66% 5. 16.66, 20%
5. At a certain rate of simple interest, a principal becomes three times in 15 years. In how many
years will the principal amount become nine times?
1. 45 years 2. 30 years 3. 60 years 4. 75 years 5. None of these
6. What approximate rate per annum of simple interest would yield the same amount as that got at
compound interest rate of 20% p.a. when the same principal is kept for three years in both the
cases.
1. 72.8% 2. 64% 3. 32% 4. 21.33% 5. 24.23%
7. What will the approximate amount be after 3 years if I deposit Rs. 5000 in a bank which offers
me a rate of interest of 5%.
1. Rs 5750 2. Rs 5760 3. Rs 5770 4. Rs 570 5. Rs 5790
8. The population of a city grows at a rate of 5% per annum. If in 2006 its population is
18,52,200, what was its population in 2004?
 1. 12,60,000 2. 13,60,000 3. 15,60,000 4. 16,00,000 5. 16,80,000
9. The property prices appreciate at a rate of 7% per annum. I bought a house in the year 2003
which had cost me Rs. 10,00,000 at that time. What will be its approximate cost three years later?
1. 12,60,000 2. 12,23,000 3. 12,25,000 4. 12,27,000 5. 12,29,000
10. I bought an Astra two years back. Its value depreciated by 9% every year. If at present its value
is Rs. 9,10,910, at what cost had I bought it?
1. 10,91,910 2. 10,9,190 3. 10,00,000 4. 11,00,000 5. 12,00,000
11. On investing Rs. 5000 in a bank, you will get back Rs. 5671 in 2 years. What is the
approximate compound rate of interest?
1. 5% 2. 5.5% 3. 6% 4. 6.5% 5. 7%
12. A bank offers a rate of interest of 16% per annum, compounded semi annually. What will be the
approximate interest generated on an amount of Rs. 10,000 kept for 2 years?
1. Rs 3600 2. Rs 3605 3. Rs 3610 4. Rs 3615 5. Rs 3620
13. Which of the following two schemes is more beneficial to a depositor with a two year investment
horizon?
(i) Rate of interest 6% compounded annually.
(ii) Rate of interest 5% compounded semi-annually.
1. (i) 2. (ii) 3. Both are same 4. Depends on principal amount
14. I deposited an amount of Rs. 20,000 at a 10% p.a. rate of interest compounded quarterly. What
is the approximate amount due to me at the end of one year?
1. Rs 22,000 2. Rs 22,025 3. Rs 22,050 4. Rs 22,075 5. Rs 22,100
15. A cooperative bank lent Rs.4000 to Anand at a certain rate of simple interest and Rs.5000 to
Milind at ½% more than that of Anand. After 2 years the bank received Rs. 860 as total interest
from Anand and Milind. Find the rate of interest per annum at which the amount was lent to
Milind.
1. 5% 2. 4.5% 3. 5.5% 4. 4% 5. None of these

Compound Interest
In the case of Compound Interest, after a fixed time intervals (again pre-determined and agreed
to by the giver and receiver) the interest amount is calculated on the principal and this interest
amount is added to the principal to determine the current outstanding amount. Then during
the next time interval, Interest is charged on the current outstanding amount and not on the
principal. Again this interest is added to find the outstanding amount. This process is
continued for successive time intervals.
Explanation of the above using a numeric example:
Consider a loan of Rs. 1000 is taken with compound interest being charged at a rate of 10%
p.a. Read the following table row-wise.

Year Amount outstanding Interest charged this Amount outstanding

at start of year year at end of year

1st year 1,000 100 1,100

2nd year 1,100 110 1,210
 3rd year 1210 121 1,331

4th year 1,331 133.1 1,464.1

Compounding
Compounding is the process of adding the interest accrued to the principal. In the above
example the interest was added back to the principal at the end of every year. Hence it is called
annual compounding.
However note that the interest of Rs. 100 earned in the 1st year is not earned on the 365th day
of the year. It is continuously being earned throughout the year. Thus, after 6 months, the
interest earned would have been Rs. 50. However one waits for the entire year to pass before
adding it back to the principal, because it is a case of annual compounding.
Had the giver and receiver agreed on a 6-months compounding, called semi-annual
compounding, the time period would have been measured in spans of 6 months and the
principal would be increased by the interest accrued every six months. In that case the table
would look like:

Time period Amount outstanding Interest charged this Amount outstanding

at start of time time period at end of time period
period

First 6 months 1000 100/2 = 50 1050

Second 6 months i.e. 1050 105/2 = 52.5 1102.5

1 yr from start

Third 6 months 1102.5 110.25/2 = 55.125 1157.625

Fourth 6 months i.e. 1157.625 115.76/2= 57.88 1215.505

2 year from start

Compounding can be any time period – annually, semi-annually, quarterly, monthly, daily. There is also a case of
continuous compounding where the time period is considered very very small, i.e. interest earned every moment is
being added back to the principal and interest earned in next time period being found on this increased principal. But
this case of continuous compounding is out of scope for our purposes.

n
⎛ r ⎞
A = P ⎜1 + ⎟
The formula in case of CI is:! ⎝ 100 ⎠ , where r is the agreed rate for a predefined interval
of time and n is the number of time periods the loan is taken or amount is deposited for.
This formula gives us the final outstanding amount and NOT the Compound Interest.
Compound Interest = Amount – Principal
E.g. 5: A bank charges a rate of interest of 10% compounded annually. What is the total
amount to be paid on a loan of Rs. 36000 for 2 yrs?
 2
⎛ 10 ⎞ 121
A = 36,000 ⎜1 + ⎟ = 36,000 ×
Using the above given formula, ! ⎝ 100 ⎠ 100 = Rs. 43,560
E.g. 6: A man takes a loan of Rs. 1,00,000 for two years at compound interest. If he has to
return Rs. 1,10,250, find the rate of interest charged.
2
⎛ r ⎞
⎜1 + ⎟
Using the formula we have 1,10,250 = 1,00,000! ⎝ 100 ⎠

Doing this calculation and finding the square root is going to be a cumbersome process. The
better alternative is to make an educated guess and then confirm this by squaring as follows:
The man pays an interest of Rs. 10,250 on a principal of 1,00,000. Thus the interest paid in
two years is a little over 10%. A good guess would be that the interest rate per annum is 5%.
Assuming it is 5% and finding the square of 1.05 we see that 1.052 = 1.1025.
Thus we can confirm that the interest rate was indeed 5%.
E.g. 7: Manu lends a sum of money to his friend at interest such that the amount triples after
5 years when compounded annually. In how many years would the amount payable back
become 9 times the sum loaned?
5 5
⎛ r ⎞ ⎛ r ⎞
3P = P ⎜1 + ⎟ ⇒ ⎜1 + ⎟ =3
Here Amount becomes thrice the Principal. So, ! ⎝ 100 ⎠ ⎝ 100 ⎠
n n
⎛ r ⎞ ⎛ r ⎞
9P = P ⎜1 + ⎟ ⎜1 + ⎟ =9
The question requires us to find n when ! ⎝ 100 ⎠ i.e. when ! ⎝ 100 ⎠ .
⎛ r ⎞
⎜1 + ⎟
Denoting ⎝ 100 ⎠ as f, we have f 5 = 3 and we want to find f n = 9. Obviously since 9 is square
of 3, we will have f 10 = 9. Thus the amount will become 9 times the principal in 10 years.
Alternate method: In the case of compound interest, it is a fresh beginning after every
compounding. Thus after 5 years, when the principal triples, it is as good as a fresh beginning.
In the next 5 years this amount, 3P, will again triple i.e. will become 9P. Thus, in a total of 10
years, the amount will become 9 times.

⎛ r ⎞
⎜1 + ⎟
! ⎝ 100 ⎠ as a multiplying factor
⎛ r ⎞ 11
⎜1 + ⎟
With r = 10%, ! ⎝ 100 ⎠ will become 1.1 or ! 10
⎛ r ⎞ 6
⎜1 + ⎟
With r = 20%, ! ⎝ 100 ⎠ will become 1.2 or ! 5
⎛ r ⎞
⎜1 + ⎟
The term ! ⎝ 100 ⎠ is nothing but the multiplying factor equivalent to a r % increase. Thus, just
⎛ r ⎞
⎜1 + ⎟
to save space and to think on lines of a percentage increase, we shall denote ! ⎝ 100 ⎠ as f.

E.g. 8: A man loans out Rs. 50,000 at a rate of 8% simple interest for 2 years and another Rs.
50,000 at the same rate compounded annually for 2 years. Is there any difference in the two
amounts he gets back after 2 years?
Lets first calculate the total amount in the case of Simple Interest
50,000 × 8 × 2
SI = ! 100 = Rs. 8000
Now, let’s calculate the total amount in the case of Compound Interest
A = 50,000 × 1.082 = 50,000 × 1.1664 = Rs. 58,320
This is the amount and not the CI. The CI = 58,320 – 50,000 = Rs. 8,320
Hence there is a difference of Rs. 320 in the two amounts he gets back
E.g. 9: If interest is accrued semi annually at 10% per annum, what will be the total amount at
the end of 2 years if principal is Rs. 15000.

Non-Annual Compounding
n
⎛ r ⎞
A = P ⎜1 + ⎟
The formula for non-annual compounding remains the same, ! ⎝ 100 ⎠ . The only difference being that here r
will be the rate of interest per ‘compounding period’. If in a question, it is given that compounding happens half yearly
but r is given as the rate per annum, then we will need to divide r by 2 to get half yearly rate of interest. Similarly for
quarterly compounding, if r is given as the rate per annum, then we will need to divide r by 4 to get quarterly rate of
interest.

Also remember that t here is the number of ‘compounding periods’. So if the interest is compounded half yearly, and
number of years, n is given, the number of time periods will be equal to 2 × n.

Since the interest is compounded semi annually and rate of interest is per annum, the semi
annual rate of interest will be 10/2 = 5%. Also t will be 2 × 2 = 4.
4 4
⎛ 5 ⎞ ⎛ 21 ⎞
⎜1 + ⎟ = 15,000 × ⎜ ⎟
So A = 15,000! ⎝ 100 ⎠ ⎝ 20 ⎠ = Rs. 18,233
E.g. 10: If a bank offers two schemes (i) Annual compounding at 11% (ii) Semi-annual
compounding at 10%, which of the two is a better scheme for depositors who want to deposit
their money for two years?
Let’s assume principal to 100.
Case (i) In case of annual compounding r = 11%, t = 2
So A = 100 × 1.12 = 121.
Case (ii) In case of Semi-annual compounding r = 10/2 = 5%, t = 4
So A = 100 × 1.054 = 100 × 1.10252.
One should not calculate and find the square. Remember we just need to compare and it is
obvious that 1.10252 will surely be greater than 1.12.
Hence Case (ii) of semi-annual compounding is better for the depositors.
It should be obvious that people seeking loans would prefer Case (i) since they will need to pay
less interest at the end of the year.
Note:
Population, Appreciation and Depreciation are generally calculated at compound rate of
interest unless otherwise stated. In most of the other cases unless otherwise stated, we will
assume simple rate of interest.
Unless otherwise stated, compound interest will be compounded annually.
C. I.: Case of Successive Percentage Changes
Rs. 1000 is kept in a bank at compound interest of 10% p.a. The following diagram depicts the
growth of money on a year on year basis:

!
The above representation should make it very clear that compound interest is a case of
successive percentage increases of r % every year. This fact could be used effectively in certain
situations as explained in the following example.
E.g. 11: What rate per annum of simple interest would yield the same amount as that got at
compound interest rate of 25% p.a. when the same principal is kept for three years in both the
cases.
Using formula, the amount at 25% compound rate after 3 years is P × 1.253. Finding 1.253 will
be slightly difficult.
Alternately, in compound interest the total percentage increase over the three years will be the
net effect of 25% & 25% & 25% increase.
25% & 25% increase is equivalent to 56.25% increase.
25 × 56.25
25 + 56.25 +
Thus the net increase is ! 100 = 81.25 + 14.0625 = 95.3125%
For the same percentage increase over three years in the case of simple interest, since each
95.3125
year we get the same percentage increase, the rate should be ! 3 = 31.7708 per year.
E.g. 12: The population of a city grows at a rate of 12.5% per annum. If in 2006 its population
is 7,29,000, what was its population in 2003?
9
A 12.5% increase corresponds to a multiplying factor of ! 8
9 9 9
x× × ×
Thus, 7,29,000 = 8 8 8 , where x is the population in year 2003. Since 93 = 729 and 83 =
512, we can find x = 5,12,000
This approach is better than finding 1.1253
Compound Interest as a Case of Interest on Interest
In competitive exams there are many questions involving comparing simple interest and
compound interest in the first two years or comparing the compound interest in two successive
years. So let’s look at this more thoroughly:
Compound Interest In Successive Years
In the case of compound interest the amount on which interest is calculated, keeps changing.
The first year, it is equal to the principal, next year it is equal to principal plus last year’s
interest, in the year after that, interest is calculated on principal plus the interest earned in the
previous two years and so on. This is what we mean by compound interest. The interest gets
compounded (added to the principal) every year. Every subsequent year, the interest calculated
for that year, will be more than the interest calculated for the previous year because the
amount on which interest is calculated would be more than the amount of the previous year.
The following figure compares the interest earned in two successive years, nth and (n + 1)th. The
picture is self sufficient to understand that, in any year, one would receive as much interest as
earned in the previous year PLUS one would earn interest on the previous year’s interest.
And this should be logical because the previous year’s interest gets added to the amount at end
of previous year.
Thus, difference in compound interest earned in two successive years is equal to the
interest on the first year’s interest.

 !
While the image does not make it very clear (the table in the following box will), a little thought
will make it obvious that since the difference is interest on previous years interest, the ratio of
compound interest earned in two successive years is (1 + r %) : 1

Mathematically

Let us say a sum is kept at r % compound interest.

Year Principal Interest in year Amount

at start of at end of
year year
 (n – 1)th Unknown Unknown x, say
nth x CIn = r % of x x + CIn

(n + 1)th x + CIn CIn+1 = r % of (x + CIn)

= r % of x + r % of
CIn
= CIn + r % of CIn

Two important conclusions from the above

1. The difference CIn+1 – CIn = r % of CIn i.e. difference between compound interest
earned in two successive years is the interest earned on interest of first of these years.
CIn +1 1 + r %
=
CIn 1
2. !

E.g. 13: If the ratio of CI in the 7th and 8th year is 10 : 11, find the rate of interest being offered.
Rather than use the formula for the ratio, the CI in the two years can be assumed as 10k and
11k. Needless to say the extra k interest earned is on 10k and hence the rate of interest is
1/10 i.e. 10%
Difference Between SI And CI In First Two Years
Consider a principal kept at simple interest at certain rate. Also consider the same amount
kept at same rate but this time at compound interest (annually). Now let us compare the two
cases over the first two years.

!
Difference between total CI and total SI earned in first two years = Interest on the first years
interest i.e. r % of I1. But I1 = r % of P. Thus, difference between the total CI and SI earned in
r2
first two years = r % of (r % of P) i.e. ! 100 % of P
Ratio of CI and SI earned in first two years:
CI earned in first 2 years 2 × (r % of P ) + r % of (r % of P ) 2 + r %
= =
SI earned in firsts 2 years 2 × (r % of P ) 2
!
E.g. 14: What is the difference between SI and CI accrued in the 2nd year (only in 2nd year, not
1st and 2nd combined) on a principal of Rs. 1000 at 8% interest?
Since the interest earned in 1st year is same whether it is SI or CI, the difference between the
total CI and SI earned in first two years is actually the difference between the CI and SI of the
82
× 1000
2nd year itself. Thus required difference = 100 × 100 = Rs. 6.40
E.g. 15: If the rate of interest is 15%, what is the ratio of the total CI earned in first 2 years to
the total SI earned in first two years if the principal kept is same?
2 + 0.15 2.15
=
It’s a straightforward application of formula found earlier i.e. ! 2 2 i.e. 43 : 40

E.g. 16: If the ratio of the total compound interest earned in firsts two years to the total simple
interest earned in first two years is 11 : 10, find the rate of interest, assuming it and the
principal to be the same in the two cases.
Rather than using the formula, one could also think on following lines:
Let total SI earned in 2 years be 10k. Thus, in the first year the SI earned, as well as the CI
earned will be 5k. Thus, in the second year, the CI earned will be 11k – 5k = 6k.
In the second year, the CI earned is more than the first years CI of 5k by k. Thus, rate of
interest is k/5k i.e. 1/5 i.e. 20%

Exercise
16. The CI earned in the 7th year is Rs. 500. If the rate of interest is 15%, find the compound
interest earned in the 8th year.
1. Rs 500 2. Rs 525 3. Rs 550 4. Rs 575 5. Rs 600
17. The compound interest earned in the 3rd and 4th year is Rs. 450 and Rs. 500. Find the rate of
interest.
1. 9.09% 2. 10% 3. 11.11% 4. 12.5% 5. 15%
18. At a compound interest rate of 10%, the compound interest earned in the 8th year is Rs. 484.
Find the compound interest earned in the 6th year.
1. Rs 360 2. Rs 400 3. Rs 440 4. Rs 480 5. Cannot be determined
19. If the rate of compound interest is 12.5%, find the ratio of compound interest earned in the 24th
year and that earned in the 25th year.
1. 8 : 9 2. 9 : 8 3. 24 : 25 4. 192 : 225 5. 25 : 27
20. If the ratio of compound interest earned in the nth and the (n+1)th year is 15 : 16, find the rate of
interest.
1. 12.5 % 2. 13.33% 3. 6.66% 4. 6.25% 5. Depends on value of n
21. The difference between the compound interest and simple interest on a certain sum at 10% per
annum for 2 years is Rs. 631. Find the sum.
1. Rs 6,310 2. Rs 63,100 3. Rs 6,31,000 4. Rs 63,10,000 5. Cannot be determined
22. The difference between the compound interest and simple interest accrued on an amount of Rs.
18,000 in 2 years was Rs. 405. Find the rate of interest, if it is same in the case of simple and
compound interest.
1. 10% 2. 12.5% 3. 15% 4. 17.5% 5. 20%
23. I kept Rs. 20,000 at 5% rate of simple interest for two years. Find the difference in interest
earned if I had kept the same amount for same years at same rate but at compound interest.
1. Rs 1 2. Rs 2 3. Rs 5 4. Rs 20 5. Rs 50
24. If the rate of interest in case of both compound and simple interest is 8.33%, find the ratio of
the compound interest and simple interest earned in first 2 years on the same principal.
1. 25 : 24 2. 24 : 25 3. 11 : 12 4. 12 : 1 5. None of these