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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Below mentioned are the benefits of compound interest:
Below mentioned is how compound interest helps you:
SEE ALSO: Benefit Of Compound Interest
The table below shows the comparison of compound interest with simple interest:
The formula to calculate compound interest CI, is as shown below:
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.
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.
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).
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
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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