Interest is the core mechanism by which banks make money and encourage savings. Understanding how banks calculate interest on loans and deposits is crucial for managing personal finances effectively.
Whether you are taking a personal loan, mortgage, or saving in a fixed deposit, knowing how interest is calculated can save money and help you maximize returns.
In 2025, with fluctuating interest rates and multiple banking products available, understanding interest calculation methods has become even more essential.
What Is Interest?
Interest is the cost of borrowing money (loans) or the reward for saving money (deposits), expressed as a percentage over time.
- Loans: Borrowers pay interest to the bank.
- Deposits: Banks pay interest to savers.
Interest is influenced by principal, rate, time, and compounding frequency.
Key Terms to Know
| Term | Definition |
|---|---|
| Principal | Initial amount borrowed or deposited |
| Rate of Interest (ROI) | Percentage charged or earned annually |
| Time | Duration of loan or deposit |
| Simple Interest | Interest calculated only on principal |
| Compound Interest | Interest calculated on principal + accumulated interest |
| Compounding Frequency | How often interest is added (daily, monthly, quarterly, annually) |
How Banks Calculate Interest on Loans
Banks primarily use two methods to calculate loan interest:
- Simple Interest
- Compound Interest / Reducing Balance Method
1. Simple Interest
Simple interest is calculated only on the principal throughout the loan term.
Formula:SI=P×R×T
Where:
- SI = Simple Interest
- P = Principal
- R = Annual Interest Rate (%)
- T = Time in years
Example:
Loan: $10,000
Rate: 8% per annum
Time: 3 yearsSI=10,000×0.08×3=$2,400
Total Repayment: $10,000 + $2,400 = $12,400
Common Use: Short-term loans, some personal loans.
2. Compound Interest / Reducing Balance Method
Most modern loans use compound interest, also called reducing balance method. Interest is calculated on the outstanding principal, reducing over time as you repay.
Formula:EMI=(1+r)n−1P×r×(1+r)n
Where:
- P = Loan Amount
- r = Monthly Interest Rate (annual rate ÷ 12)
- n = Total number of monthly payments
Example:
Loan: $10,000
Rate: 8% per annum
Term: 3 years (36 months)
Monthly interest: 8 ÷ 12 = 0.6667%
EMI calculation gives monthly payment ~$313.36
Advantages:
- Reflects decreasing principal
- Fairer to borrower
- Widely used for mortgages, car loans, and long-term loans
How Banks Calculate Interest on Deposits
Banks also calculate interest on deposits to encourage savings. Deposit interest can be:
- Simple Interest
- Compound Interest
1. Simple Interest on Deposits
Simple interest is paid on the principal amount only.
Formula:SI=P×R×T
Example:
Deposit: $5,000
Rate: 6% per annum
Time: 2 yearsSI=5,000×0.06×2=$600
Maturity Amount: $5,600
Common Use: Short-term deposits, recurring deposits.
2. Compound Interest on Deposits
Most banks offer compound interest, which earns interest on both principal + previously earned interest.
Formula:A=P×(1+nr)n×t
Where:
- A = Maturity Amount
- P = Principal
- r = Annual Interest Rate
- n = Compounding Frequency (annual, semi-annual, quarterly, monthly)
- t = Time in years
Example:
Deposit: $5,000
Rate: 6% per annum
Compounding: Quarterly (n=4)
Time: 2 yearsA=5000×(1+40.06)4×2=$5,618.93
Tip: Higher compounding frequency → higher returns. Daily compounding yields the most.
Comparison: Loan vs Deposit Interest
| Feature | Loan Interest | Deposit Interest |
|---|---|---|
| Purpose | Borrowing | Saving |
| Who Pays | Borrower | Bank |
| Calculation | EMI (reducing balance) or SI | SI or CI |
| Compounding Effect | Cost increases if frequency is high | Earnings increase if frequency is high |
| Typical Rate | Higher | Lower |
Factors Affecting Interest Calculation
- Principal Amount – Larger loans or deposits increase total interest.
- Interest Rate – Annual percentage rate set by bank or central bank policies.
- Time Period – Longer tenure → higher total interest.
- Compounding Frequency – Daily, monthly, quarterly, or annually.
- Type of Loan/Deposit – Fixed, recurring, floating, or variable.
Tips to Optimize Loan Payments
- Opt for shorter tenure if possible → reduces total interest.
- Prepay loan partially to lower outstanding principal.
- Choose loans with lower processing fees.
- Compare reducing balance vs flat rate loans.
Tips to Maximize Deposit Earnings
- Select higher compounding frequency (daily > monthly > quarterly).
- Use high-yield savings accounts or fixed deposits.
- Reinvest interest earned to leverage compounding.
- Diversify deposits across banks for better rates.
Real-Life Example: Comparing Loan and Deposit Interest
| Scenario | Amount | Rate | Term | Interest/Maturity |
|---|---|---|---|---|
| Personal Loan | $10,000 | 8% p.a. | 3 yrs | $2,400 (SI) |
| Home Loan | $100,000 | 7% p.a. | 15 yrs | $82,500 (Reducing EMI) |
| Fixed Deposit | $5,000 | 6% p.a. | 2 yrs | $618.93 (CI quarterly) |
Insight: Compounding significantly increases deposit returns over time and reduces loan burden if prepayments are made.
Common Mistakes People Make
- Confusing simple and compound interest → miscalculates repayment or savings
- Ignoring loan processing fees or penalties
- Not considering tax on interest earned from deposits
- Failing to compare different banks for better rates
FAQs
What is the difference between simple and compound interest?
Simple interest is calculated only on principal; compound interest is calculated on principal + accumulated interest.
Why do banks compound interest differently?
Banks compound interest to encourage savings or reflect loan costs accurately. Frequency affects total returns.
What is a reducing balance loan?
Interest is calculated on the remaining principal after each EMI, reducing the total interest paid over time.
How does compounding frequency affect deposit returns?
Higher frequency (daily > quarterly > annually) increases total interest earned.
Are bank interest rates fixed or variable?
It depends; some loans/deposits have fixed rates, while others vary with market or policy rates.
Related External Resources
- Investopedia – How Banks Calculate Interest
https://www.investopedia.com/terms/i/interest.asp - Consumer Financial Protection Bureau – Understanding Interest
https://www.consumerfinance.gov/consumer-tools/credit-cards/interest-rates/ - Federal Reserve – Bank Interest Rates Explained
https://www.federalreserve.gov/monetarypolicy.htm - NerdWallet – How Interest Works
https://www.nerdwallet.com/article/banking/interest-rate - Morningstar – Understanding Loan and Deposit Interest
https://www.morningstar.com/articles/1023450/interest-rates-basics