What Is Compound Interest?

Compound interest is interest earned on interest. With compound interest, the investment grows really fast. Compound interest can be compounded on a monthly, quarterly and annual basis as per the agreement. More the number of compounding, higher would be the returns earned on your investment. Longer investments would offer higher returns as interest would be compounded more number of times.

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What Is Compound Interest?

Benefit Of Compound Interest

Below mentioned are the benefits of compound interest:

• Better returns: Returns earned through compound interest is much higher than simple interest.
• Better wealth management: Your wealth would be managed in a better way by investing in investment options that offer returns based on compound interest.
• Interest earned is compounded over time: The interest earned by the previous compounding is added to the principal thereby enhancing your returns when the interest is compounded next time.
• Rapid returns: The returns would be earned at a rapid pace if the number of compounding is high.

How Compound Interest Helps You?

Below mentioned is how compound interest helps you:

• To enjoy maximum benefits of compound interest, you must sacrifice and save today to reap benefits tomorrow: Compound interest requires longer investment tenure to offer best returns. It’s advisable to start planning for the future by investing in those schemes that offer returns based on compound interest.
• It is not necessary that you must be rich to enjoy the benefits of compound interest: The returns earned by compound interest correspond to your investment, be it Rs 1,000 or Rs 10 Lakhs.
• Compound interest is a double-edged sword: It’s good if you are on the receiving side of compound interest, but if you are on the other side, then it works against you. Imagine paying compound interest on loans.
• Interest can be compounded as often as possible: More the number of times the interest is compounded, higher would be the returns earned. It’s good to compound interest on a quarterly basis instead of an annual basis. The opposite is good if you are on the paying side.
• Your investment grows faster than you think: You save Rs 5 each month and deposit in a scheme offering returns based on the compound interest. As per the scheme, you are earning 5% interest compounded each month, doing this continuously for 10 years, you would have saved Rs 600 in the account, but the account’s worth Rs 776, thanks to compound interest. It would be worth Rs 1,500 by the next 15 years, even if you don’t add a single rupee to the account.

SEE ALSO:  Benefit Of Compound Interest

Compound Interest Vs Simple Interest

The table below shows the comparison of compound interest with simple interest:

The formula to calculate compound interest CI, is as shown below:
 

Compound Interest Formula

A = P (1+R/n)^nt

A = Amount at the end of the duration of investment.

P = Principal amount invested.

R = Rate of interest offered on the investment.

N = Number of times the interest is compounded in a year. This can be monthly (N=12), quarterly (N=4), half yearly (N=2) and annually (N=1).

T = Period of investment.

Compound Interest Example

Consider the below example:

You invest Rs 2,00,000 in a scheme offering a rate of interest of 9% for 6 years and the interest 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 = (2,00,000*6*9)/100

SI = 1,08,000

Total amount = SI + Principal = 2,00,000 + 1,08,000 = Rs 3,08,000

In case of Compound Interest:

A = P (1+R/n)^nt

A = Amount at the end of 6 years.

P = Principal invested, that is Rs 2,00,000.

R = rate of interest offered on the investment

N = 4 (compounded once for every 3 months out of the 12 months of a year, in short it’s 4 times a year)

T = time period of the investment = 6 years.

A = 2,00,000 (1+ 0.09/4) ^ (4*6) = Rs 3,41,153.32.

CI = A - P = Rs 3,41,153.32 – Rs 2,00,000 = Rs 1,41,153.32.

The above example shows that the interest earned through compound interest is much higher than the interest earned through simple interest.

Interest Rate

Interest plays a very important part in investments. Money is being lent or borrowed by individuals, banks or other financial institutions for a consideration known as interest.

Where,

P= amount give to borrower, also called principal amount.
R=Interest earned on amount P and also known as charges.

The rate of interest is also decided between them. Interest is charged because of the time value of money.

Terms to Remember

• Principal (P): The amount of money that is originally invested or loaned (lent or borrowed) is called the principal (or the present value of the money).

• Interest (I): Interest is consideration (or fee) for the use of invested or loaned (capital or principal).
• Time (T): The time is the number of years or fraction of a year for which the principal is borrowed or loaned.
• Amount (A): The amount is the sum of the principal and the interest earned in the specified time and also known as accrued amount (or the future value).

Rate of Interest

It is the money payable for the use of unit principal for unit interval of time (unit interval of time : years, six months, three months or a month). Correspondingly rate of interest is payable annually (per annum or p.a.), half-yearly (or semi-annually), quarterly or monthly.

See Also: Home Loan Interest Rate

Types of Rate of Interest

There are two important kinds of interest such as;

Simple Interest

In simple interest the principal remains the same throughout the term of the loan. For example simple interest on Rs.100 at 6% per annum will be Rs.6 each year, i.e., at the end of the first year, the total amount will be Rs.106 and at the end of the second year it will be Rs.112 and so on. If Rs. P be the given principal loaned at the rate R% per annum for a period of T years.
Then simple interest, I =PRT (I is multiplication of P x R x T)

Compound Interest

Compounding interest is the second method for borrowing or lending money on interest. In this case principal keeps on changing at the end of each period of time.

Concept of compounding interest is very important not only for those who are planning a career in financial institutions but even for ordinary investors who wish that their savings keep on growing steadily and he same become a source of income for them.

Power of compound interest - In compound interest, unpaid interest over any unit of time, also earns interest over the subsequent units of time.

When ‘N’ becomes larger and larger and we compute the interest, the more will be the compounding amount.

In compound interest the principal doesn’t remains the same throughout the term of the loan. For example compound interest on Rs.100 at 10% per annum will be Rs.10 for first year, i.e., at the end of the first year, the total amount will be Rs.110 and at the end of the second year it will be the total amount at the beginning of the second year plus the rate of interest, i.e., Rs.110/- + 10% on Rs.110 which is equal to Rs.121/-p and so on.

If Rs. P be the given principal loaned at the rate R% per annum for a period of T years.
Then simple interest, I =PRT (I is multiplication of P x R x T)

CI = P (1+R) N

Where;
CI = Compound Interest
P = Principal
R = Rate of Return
N = Number of Years.

Example

Below given example will help you to understand the difference in growth of Rs. 100000 in simple interest and compound interest during a period of 10 years. The interest rate is assumed as 10% per annum.

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