Simple interest
Interest earned only on the amount you first put in (the principal). The interest is not added back, so it never earns interest of its own, unlike compound interest.
In plain language
Simple interest is the most basic way money earns money. You put in an amount, called the principal, and every year you get interest on that same amount only.
The interest you already received does not join the principal. So the yearly interest stays the same, year after year.
The booklet explains it in one line: "With simple interest, you can earn interest only on the principal (that is, the amount you initially invested); while with compounding interest, you earn interest on the principal as well as, previously earned interest."
It is taught mainly so that you can see what you lose by not compounding. Over a few months the gap is small. Over decades it is huge.
How it works
The booklet's own example (Chapter 2, "What is Power of Compounding?") uses Rs 1,000 at 9% a year for 40 years:
| Simple interest | Compound interest | |
|---|---|---|
| Interest in year 1 | Rs 90 | Rs 90 |
| Interest in year 2 | Rs 90 | Rs 98 (9% of Rs 1,090) |
| What earns interest | Always Rs 1,000 | Rs 1,000 plus all interest earned so far |
| Value after 40 years | Rs 4,600 | Rs 31,409 |
With simple interest, "the principle amount remains at Rs 1,000/- only for all the 40 years and with annual interest of Rs 90/-, the amount grows to only Rs 4,600/-." With compounding, the principal plus the first year's return becomes the principal for the second year, and so on.
Same money, same rate, same 40 years. The only difference is whether the interest is put back to work.
The formula
Simple interest = Principal × Rate × Number of years
Maturity value = Principal + Simple interest
Booklet check: 1,000 × 9% × 40 = Rs 3,600 interest. 1,000 + 3,600 = Rs 4,600.
A worked example
Amounts and rates are illustrative.
Kavitha, a nurse in Coimbatore, has Rs 50,000 to put away for 5 years at 8% a year.
Option 1: interest paid out every year (simple interest).
Yearly interest = 50,000 × 8% = Rs 4,000
Interest over 5 years = 4,000 × 5 = Rs 20,000
Total at the end = 50,000 + 20,000 = Rs 70,000
Option 2: interest added back each year (compounding).
Year 1: 50,000 × 1.08 = 54,000
Year 2: 54,000 × 1.08 = 58,320
Year 3: 58,320 × 1.08 = 62,985.60
Year 4: 62,985.60 × 1.08 = 68,024.45
Year 5: 68,024.45 × 1.08 = Rs 73,466.40
Compounding gives her about Rs 3,466 more in 5 years. If she spends the Rs 4,000 each year, she is choosing simple interest, and the gap keeps growing the longer the money stays invested.
Why NISM asks about it
Chapter 2 (Key Concepts in Personal Finance) defines simple interest while explaining the power of compounding, with the Rs 1,000 at 9% for 40 years table. Expect a direct question: what does Rs 1,000 grow to under simple interest (Rs 4,600) versus compounding (Rs 31,409)?, or a definition question on what earns interest under each method.
Common exam traps
- Simple interest is on the principal only. Any option saying it is paid on "principal plus earlier interest" is describing compound interest.
- The yearly interest does not change under simple interest (Rs 90 every year in the booklet's example).
- Rs 4,600 is simple; Rs 31,409 is compound. Do not swap them.
- Same rate, same period, very different result. The difference comes only from reinvesting the interest.
- The booklet spells "principal" as "principle" in one place. It means the amount invested.
Where this is taught
- Series SEBI-ICE · Chapter 2: Key Concepts in personal financeintroduced here
- Series X-A · Chapter 2: Time Value of Moneyintroduced here
Related terms
- InflationA sustained general rise in the price level, which erodes what a rupee buys — and the reason a nominal return has to be deflated before it means anything.
- Compound interestInterest earned on the original amount and also on the interest already earned. Rs 1,000 at 9% grows to Rs 31,409 in 40 years compounded, against Rs 4,600 with simple interest.
- Fixed DepositMoney placed with a bank for a fixed term at an agreed rate of interest. Safe and simple, but the interest is taxable, and TDS applies once interest crosses a stipulated amount.
- Time value of moneyThe principle that the same sum of money is worth different amounts at different points on a timeline, because money held today can be invested and because inflation erodes what it will buy.
- Future valueWhat a sum of money invested today will be worth at a future date once returns have been earned and reinvested — the compounding half of the time value of money.