Compound interest is basically interest on interest. It is the addition of interest to the principal sum of a deposit. Interest is reinvested rather than paid out.
With compound interest, investment grows faster. Compound Interest enables investors earn more on their investment. Compound Interest can be compounded on a daily or a monthly or a quarterly basis, as per the agreement. More the number of compounding higher will be the returns. So, longer the investment, higher will be the returns.
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Formula to calculate the amount earned with compound interest is shown:
A = P (1+R/n)nt
Where ‘P’ stands for the principal, ‘n’ stands for the number of compounding ‘t’ stands for the investment tenure and ‘r’ is rate of interest.
Below mentioned are the major differences between simple and compound interest:
Simple Interest |
Compound Interest |
Charged only on principal |
Charged on principal along with interest |
Is a small portion of principal |
A small percentage of principal and simple interest earned |
Returns are lower |
Returns are higher |
Wealth growth is lower |
Wealth growth will be higher |
Principal remains constant |
Principal increases with time |
Formula; SI = (P*T*R)/100 |
Formula A = P(1+R/n)nt |
Consider the following example; You invest INR 1,00,000 in a scheme at a rate of interest of 8% for 5 years. The amount is compounded on a quarterly basis.
In case of Simple Interest:
SI = (P*T*R) / 100
P = Principal
T= Period of investment
R = Rate of interest
SI = (1,00,000*5*8)/100
SI = 40,000
Total amount = SI + Principal = 1,00,000 + 40,000 = Rs 1,40,000.
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In case of Compound Interest:
A = P (1+R/n)nt
A = Amount at the end of 5 years.
P = Principal invested
R = rate of interest paid
N = 4(compounded for 3 months out of 12 months or 4 times a year).
T = time period of the investment= 5 years.
A = 1,00,000 (1+ 0.08/4) ^ (4*5) = INR 1,48,595.
As you notice from the above example, the returns earned through compound interest are higher than the returns earned through simple interest.
The Rule of 72 is a simple way to determine how long an investment would take to double, given a fixed annual interest rate. The rule of 72 is highly accurate when the interest rates are low. The rule of 72 divides 72 by the annual rate of return/interest, investors can get a rough idea on how long investment would take to double.
Year |
Opening Balance |
Interest at 5% |
Closing Balance |
1 |
Rs 10,000 |
Rs 500 |
Rs 10,500 |
2 |
Rs 10,500 |
Rs 525 |
Rs 11,025 |
3 |
Rs 11,025 |
Rs 551.2 |
Rs 11,576.2 |
If the interest rate is 8% on an investment of Rs 4,00,000, then as per rule of 72, the investment would double (Rs 8,00,000) in
Time (T) = 72 / x; Where x = rate of interest.
T = 72/8 = 9 years;
Therefore, an FD offering returns of 8% would double your money in 9 years. Compound interest needs longer time to get maximum benefits and hence fixed deposits have longer duration to maturity.
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Advantages of Compound Interest:
Facts about compound interest that you should know
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