Most financial products use compound interest — bank deposits, investments, and most loans. Understanding the difference between simple and compound interest explains why long-term savings grow faster than expected, and why loans can end up much more expensive than the headline rate suggests.
Simple Interest
Interest is always calculated on the original amount (principal). It doesn't grow — it adds the same fixed amount each period.
Formula: Interest = Principal × Rate × Time
- Rs 10,000 at 10% per year for 3 years:
- Interest = 10,000 × 0.10 × 3 = Rs 3,000
- Total after 3 years: Rs 13,000
Simple interest is used for short-term loans, some government bonds and straightforward calculations.
Compound Interest
Interest is calculated on the principal plus all previously earned interest. Each period, the base grows, so each period's interest is larger than the last.
Formula: A = P × (1 + r/n)^(n×t)
- A = final amount, P = principal, r = annual rate (decimal), n = compounds per year, t = years.
- Rs 10,000 at 10% per year, compounded annually for 3 years:
- Year 1: 10,000 × 1.10 = 11,000
- Year 2: 11,000 × 1.10 = 12,100
- Year 3: 12,100 × 1.10 = Rs 13,310
- Vs simple interest: Rs 13,000
The difference seems small at 3 years. At 20 years:
- Simple: Rs 30,000
- Compound: Rs 67,275
The Power of Compounding Frequency
More frequent compounding = faster growth. Same 10% annual rate on Rs 10,000 for 5 years:
| Compound frequency | Final amount |
|---|---|
| Annually | Rs 16,105 |
| Quarterly | Rs 16,386 |
| Monthly | Rs 16,453 |
| Daily | Rs 16,487 |
The difference between annual and daily is modest, but versus simple interest it's significant.
Which Are You Dealing With?
Savings accounts: almost always compound (in your favour). Personal loans and credit cards: compound (against you). Use Compound Interest Calculator to model any scenario. For how this affects loan repayments specifically, see how to calculate EMI on a loan.
In Practice: Which Are You Dealing With?
Pakistani savings accounts and term deposits typically use compound interest, calculated and added monthly or quarterly. Islamic banking products (murabaha, ijarah) have different structures that may not fit the simple/compound framework directly — the return is built into the pricing structure differently. For calculating any specific scenario with monthly compounding, Compound Interest Calculator lets you set the compounding frequency. For loan costs specifically, see how to calculate EMI on a loan.
