Simple interest is the more basic of the two ways interest is calculated. It applies only to the original principal for the whole term, and interest already earned never earns anything further.
The formula is:
Simple interest = Principal times Rate times Time, divided by 100, where rate is per year and time is in years.
Its counterpart, compound interest, adds each period's interest back to the balance so the next period's interest is charged on a larger amount. That single difference is why simple interest is a poor deal when you are saving and, deceptively, an expensive deal when you are borrowing.
A worked example on savings
Invest Rs 1,00,000 at 8% a year for 10 years.
Under simple interest you earn Rs 8,000 every year without variation. Over 10 years that is Rs 80,000, and the total value is Rs 1,80,000.
Under annual compounding, the same Rs 1,00,000 at 8% grows to roughly Rs 2,15,890, so interest earned is about Rs 1,15,890.
The gap is roughly Rs 35,890 on the identical rate and term, and it widens sharply with time. Over 20 years the simple interest total is Rs 2,60,000 while compounding reaches about Rs 4,66,000. Test this with the compound interest calculator.
Where you actually meet simple interest in India
Genuine simple interest is rarer than people assume, but it appears in several places worth recognising.
Savings account interest is calculated on the daily closing balance and typically credited quarterly, at which point it starts earning too, so it is effectively compounded quarterly rather than simple.
Most bank fixed deposits compound quarterly. However, a non-cumulative FD, where interest is paid out monthly or quarterly instead of being reinvested, behaves like simple interest from the depositor's point of view, because the payout never joins the principal. This is a real and reasonable choice for retirees who need the income, but it is important to know it earns less than the cumulative option over the same term.
Short-term loans of under a year, some corporate fixed deposits, certain post office instruments and many informal loans are also quoted on a simple interest basis.
The flat rate trap on car and consumer loans
This is where simple interest costs borrowers real money. Some dealers, consumer finance companies and NBFCs quote a flat rate, where interest is computed on the original loan amount for the entire tenure even though your outstanding balance falls every month.
Take a Rs 2,00,000 car loan quoted at "8% flat" over 5 years.
Interest is Rs 2,00,000 times 8% times 5, which is Rs 80,000. Total repayment is Rs 2,80,000, so the EMI is Rs 2,80,000 divided by 60, which is Rs 4,667.
That looks cheap next to a bank quoting 14%. It is not. By the final year you owe only a fraction of the original Rs 2,00,000, yet you are still being charged interest as though the full amount were outstanding. The equivalent reducing-balance rate on that EMI is roughly 14.2%, close to double the quoted flat rate.
| Basis | Quoted rate | What interest is charged on | EMI on Rs 2 lakh over 5 years |
|---|---|---|---|
| Flat or simple | 8% | The original Rs 2,00,000, every month | About Rs 4,667 |
| Reducing balance | 14.2% | The falling outstanding balance | About Rs 4,667 |
The two rows describe the same loan. A flat rate roughly doubles when converted to a reducing-balance rate, so always ask for the reducing-balance or annual percentage rate before comparing offers, and check the EMI itself with the car loan EMI calculator rather than trusting the headline percentage.
The rule of thumb worth remembering
You want compounding on money you are saving and reducing-balance calculation on money you are borrowing. Any product that offers you the reverse is doing so because the reverse is cheaper for the institution.
When you are shown a rate, ask one question: is interest charged on the original amount or on what I still owe? The answer changes the true cost by nearly a factor of two, and it is the fastest way to compare two loans that look nothing alike on paper. The mechanics of the alternative are covered under amortisation.