Understanding Interest - Definition, Mechanisms, and Examples

Understanding Interest - Definition, Mechanisms, and Examples

30 May 2024 | By INDIE

Understanding the concept of interest is important in various aspects of personal finance and the economy as a whole. For investments, the interest rate incentivizes investors by encouraging them to save and invest. However, when it comes to borrowing and lending, interest determines the cost of borrowing. In short, bank interest has a significant impact on key personal finance decisions.


What is Interest?

Interest is the return on your investment or money you lent out or the price you pay for the money borrowed. Typically, interest is expressed at an annual percentage rate and calculated as a percentage of the initial invested or borrowed amount.

Interest is a fundamental concept in finance that can be used in different contexts, such as savings account interest rates, interest on fixed deposits, bonds, credit cards, and loans. For example, you will receive interest from the bank for money invested in fixed deposits. but will need to pay interest to the bank for money borrowed, e.g. A home loan. Interest rates on loans are set by the banks depending on various factors such as the prevailing market rate, your credit score, the duration of the loan, and more. The lower interest rate makes borrowing more affordable.

Also read: Why a fixed deposit is a good investment?


How does interest work?

Before understanding how interest works in different ways, it is important to know how it is calculated and the two main types of interest. Here is the formula to calculate interest:

Interest (I) = Principal (P) X Rate of interest (R) X Time (T)

In this,

Principal - initial amount you invest/borrow

Rate of interest – Percentage of return on your investment/ fee charged on borrowing

Time – duration of investment/ tenure for which money is borrowed

The main two types of interest are – simple interest and compound interest

1. Simple interest

Simple interest is the interest calculated only on the initial amount invested/borrowed or principal amount.

Simple interest = Principal X Rate of interest X Time

For example, you have invested INR 1,00,000 in a fixed deposit at an interest rate of 8% per annum for three years. You would receive a simple interest of INR 24,000 on your investment.

Simple interest = 1,00,000 X 8% X 3 = 24,000


2. Compound interest

Compound interest is an interest calculated on the principal amount along with the accumulated interest for the previous period. Compound interest helps you grow your investments exponentially. Especially, the highest interest on FD (with compound interest) can help you maximise your savings significantly over the years. Here is the formula for compound interest:

Compound interest = [P (1 + r/n) nt – P]

In this,

P – principal amount invested/ borrowed

r – annual rate of interest in decimal form

n – compounding frequency per unit of time

t – investment/ loan tenure in years

Let us take an example to understand the compound interest calculation. Suppose, you invest INR 1,00,000 in a fixed deposit at an 8% per annum interest rate for three years and bank interest to be compounded quarterly. You would receive compound interest of INR. 26,824 on your investment.

Compound interest = [1,00,000 (1 + 0.08/4)3X4 – 1,00,000] =26,824

Calculation of interest works differently in different contexts depending on the type of interest applicable to the financial product. In the case of a savings account, the savings account interest rate is applied to the daily balance to calculate the interest.

Also read: Maximise your returns on INDIE’s high-interest savings account

To sum up, learning the concept of interest and its applicability is crucial for every investor/borrower. Understanding interest, its types, and how it works in different contexts can equip you with key financial skills, enabling you to make rational investment decisions. A detailed understanding of basic finance concepts can help you plan your finances effectively to achieve your long-term financial goals.




The information provided in this article is generic and for informational purposes only. It is not a substitute for specific advice in your circumstances. Hence, you are advised to consult your financial advisor before making any financial decision. IndusInd Bank Limited (IBL) does not influence the views of the author in any way. IBL and the author shall not be responsible for any direct/indirect loss or liability incurred by the reader for making any financial decisions based on the contents and information.