What is Interest?

Movie Case Study

The scene that you just saw shows you how Devdas (played by Shah Rukh Khan) is asking for interest from Paroo (played by Aishwarya Rai). Paroo had 3 coins with her which belonged to Devdas. He says that he will take an interest of Rs. 2 per month. The monthly amount that she would owe him would amount to Rs. 3*2= 6

Then he goes on to calculate this for the entire year, 6*12= Rs. 72, and then he calculates this for 13 years, which becomes 13*72= 936.

Even though he is drunk in the scene, his mathematics skills are quite good. In this blog, learning Perspectives will explore the meaning of interest.

What is Interest?

Interest is the cost of borrowing money. Similar to the scene we saw, Paroo had Devdas’s 3 rupees on which he was asking for interest.  In real life scenario, if you borrow Rs. 1,00,000 today and pay back Rs. 1,10,000 after 1 year. Interest expense will be 10%. It is this interest that gives money its time value.

There are two major types of interests that are generally used:

Simple Interest:

This interest means earning on the initial investment only. It is calculated as the initial investment times the applicable interest rate times the period of the loan or investment. Amount earned is equal to the Principal and Interest.

Krishna in this movie clearly tells this concept:

Example of Simple Interest

Suppose you put Rs. 10,000 in your savings account that pays simple interest of 10% and then withdraws this money after 3 years. The following calculation would be:

End of Year 1= 10,000*10%= Rs. 1,000; Outstanding Balance= 10,000+1000= Rs. 11,000

End of year 2= 10,000*10%= Rs. 1,000; Outstanding balance= Rs. 12,000 [ Rs. 11,000+1,000]

End of Year 3= 10,000*10%= Rs. 1,000; Outstanding Balance= Rs. 13,000 [Rs. 12,000+1,000]

You can withdraw Rs. 13,000 at the end of three years earning a simple interest of Rs. 3,000.

Compound Interest:

This is the interest one earns on the initial investment plus previous interest. Because you are earning ‘interest on interest’.

Einstein once said ” Compounding is the eighth wonder of the world” and rightfully so. Money invested on compound interest gives great results when money is invested for a longer time period.

Example of Compound Interest

Suppose you put Rs. 10,000 in your savings account that pays compound interest of 10% and then you withdraw this money after 3 years. The following calculation would be:

Initial Investment: Rs. 10,000

End of Year 1:                   Rs. 10,000*10%= 1,000;     Outstanding Balance= Rs. 11,000

End of Year 2:                  Rs. 11,000*10%= 1,100,        Outstanding Balance= Rs. 12,100

End of Year 3:                  Rs. 12,100*10%= 1,210,         Outstanding Balance= Rs. 13,310

You can withdraw Rs. 13,310 at the end of three years earning a compound interest of Rs. 3,310.

Rs. 310 represents the compounding effect which is the difference between simple and compound interest. (Rs. 3,310-3,000).

Nearly, all business applications use compounding interest.

As you can now understand, Devdas is asking for simple interest from Paroo.

Understand Interest with a Video