Compound Interest: Calculation, Formula, Benefits

Compound Interest: Calculation, Formula, Benefits

Compound Interest: Calculation, Formula, Benefits

Most of us have already studied compound interest in mathematics lessons in our school days. Some of us have even studied them in our universities. But, as usual, it happens, we don't think about them anymore. However, they are needed in adulthood by everyone involved in planning the family budget for the coming year, while deciding to open a bank account, or selecting a suitable project to invest money in. So what is it? We will talk about it in detail.

Compound interest - what is it? Example

Let's take an example to understand compound interest, this will make it much more convenient. Suppose you deposited ₹10,000 in a bank account at 10% interest per annum for 10 years without making any additional monthly instalments. In a year, you will have ₹11,000 in your account. If no one withdraws the amount, then the following year, the accruals will be made on ₹11,000. Then the income will be ₹1100 instead of ₹1000. After 10 years, following this principle, you will already have almost ₹26,000.

Simply put, compound interest is determined when the accrued interest is added to the body of deposit and considered in the further accrual of profit.

Understanding the compound interest formula

If you want to know how to calculate compound interest, it is determined by multiplying the initial principal amount by one plus the annual interest rate raised to the number of the compound period minus one. The entire initial amount of the loan is then subtracted from the resulting value.

The formula used for determining the value of compound interest is as follows:

Compound interest = Entire principal amount and future interest minus principal amount at present.

=[P (1 + r/n)nt] - P

Where:

P = Original principal

R = Interest rate

N = Number of times compounding has taken place in a year

T = Time or duration of the investment

Suppose you opt for a three-year loan of ₹10,000 at an interest rate of 10% that compounds annually. What would be the interest amount? In this scenario, it would be:

Rs [10,000(1+0.1)5] – Rs 10,000 = Rs 6,105.1

Difference between simple and compound interest

So what is the primary difference between both types of interest? When we consider simple interest, a specific percentage of interest is paid for a specific tenure. In such a case, the principal amount remains the same for each year. However, when we consider compound interest, the principal amount keeps increasing since the interest earned is added back to the principal. Lets us take a look at some differences:

How the Power of Compounding Works in Investments?

When an individual invests a specific amount, the interest gained on this amount is added to the principal amount. The new interest is earned on the changed principal amount. Simply put, compound interest earns interest from interest gained.

The longer the investment period, the higher are the returns. The sooner one starts making investments, the more money they will earn over time, and the sooner they will achieve their financial goals.

This is the reason, as a wise investor, it is necessary to leverage the power of compound interest by starting investing journeys early and regularly.

Also, it is recommended to be patient during the investment period since it's as essential as investing regularly. The compounding interest power lies in the fact that it essentially increases the principal amount every year. Such an increase in principal amount is attributed to the interest amount being reinvested. All in all, compound interest allows you to earn higher returns and has a definite edge over simple interest.

How to leverage the Power of Compounding?

Start Early: Starting your investment journey will help you make the most of the power of compounding since early investing helps build wealth to achieve long term financial goals. In addition, it also enables funds to grow over time.

Make regular investments: Financial discipline is mandatory for making investments. As an investor, it is recommended to have a clear set of goals, and one can easily achieve them by making regular investments. Small or big investors, it doesn't matter, by investing periodically and staying invested for a long period will help achieve the maximum benefits.

Have Patience: Staying invested for a long period is the key to wealth building. Never be in a hurry to earn quick bucks. Long term investment earns maximum returns because of the power of compounding. Always be patient and provide a reasonable amount of time for investments to grow significantly.

Be careful with the money: Saving is always easier said than done. However, careful spending will help in saving at least a small amount. It is not necessary to invest in a large amount. Start with small amounts, and as income increases, make sure to increase savings likewise. This way, you will achieve your financial goals comfortably.

Consider interest rates: While selecting any investment plan, keeping a check on return is essential. Furthermore, a higher annual compound interest rate signifies higher returns.

Compound interest helps investors earn interest on interest. The following are some of the basic advantages of compound interest:

● Compounding interest makes investors' money grow faster as it helps gain interest on interest.

● Longer the investment duration, the more chance to earn higher returns.

● Make sure to make regular deposits to the existing investment to add potential to compounding.

● The higher the investment period, the higher the returns will be.

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