In simple words, compound interest is the interest earned on interest. It is the outcome of reinvesting the interest, instead of paying it out. The interest earned is added to the principal and interest is again calculated on the whole amount.
With compound interest, your investment grows much faster. Compound Interest allows an investor to earn more on the investment. Compound Interest is compounded on a daily, monthly or a quarterly basis, as per the agreement. Higher the number of compounding higher would be returns. So, longer the investment tenure, higher would be returns.
In compound interest, the interest earned is not paid out; it is instead reinvested to enhance the principal which in turn generates higher returns in the next compounding period. The formula to calculate compound interest is:
A= P (1+(r/n))nt
A – Corpus at the end of compounding period
P – Principal invested
r – Rate of interest
n - Number of compounding per year
t – Tenure of investment in years
CI = A – P;
CI – Compound Interest
There are many investment options that offer compound interest on your principal. The popular compound interest investment options are:
As the amount of money you invest goes up, the compound interest makes a bigger difference to your earnings. Hence, it is a good idea to understand how compounding works on your investments and bank accounts.
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Let’s say you invest Rs 5,000 in a scheme offering compound interest and the scheme offers an annual interest rate at 5%. If the interest is compounded on a monthly basis, then the value of the investment at the end of 10 years is calculated as follows:
P = 5000.
r = 5/100 = 0.05
n = 12.
t = 10.
By substituting these values in the formula:
A = 5000 (1 + 0.05 / 12) (12 * 10) = Rs. 8,235.05.
Therefore, the investment at the end of 10 years would be Rs. 8,235.05.
The Rule of 72 is the simplest way of estimating how long an investment would take to double, when given a fixed annual rate of interest. The rule of 72 is accurate specifically when the interest rates are low. The rule of 72 divides the number 72 by the annual rate of interest. With this, investors get a rough idea on how long an investment takes to double.
If the interest rate offered is 8% on an investment of Rs 4,00,000, then as per the rule of 72, the investment would double in:
Time (T) = 72 / x; Where x = interest rate
T = 72/8 = 9 years;
Hence, an FD offering returns at 8% will double your investment in 9 years. Compound interest requires longer time to earn maximum benefits and therefore, fixed deposits are of longer duration.
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