Compounding of interest

The primary aim of making an investment is to earn returns. Compounding helps in growing the returns exponentially. Compounding of interest takes place when the interest earned on the initial amount gets added to the principal amount and starts multiplying. A variety of investments like fixed deposits and equity compound the initial amount. Similarly, compounding also happens when you avail a loan. In the case of compounding, the principal amount grows exponentially as the duration of investment increases. As one leaves the money for a longer duration, the interest earned on the initial amount gets added to the principal amount and starts earning interest.  

Everyone wants to see his/her wealth grow at a rapid pace. Rapid wealth appreciation, however, requires proper knowledge, planning and execution. With compound interest, you can grow your investments swiftly without active portfolio management or reallocations.

What is compound interest?

Compound interest is the addition of the accumulated interest to the principal amount of investment, deposit or loan for the calculation of the interest in the future. The interest earned or levied on an investment or loan can either be simple or compound. In case of simple interest, the interest amount and the principal amount remains the same throughout the tenure. Compound interest, on the contrary, works on the principle of accumulation. The accumulated interest over a period is added to the principal amount, which becomes the new principal amount for the calculation of interest. The process repeats throughout the investment, loan or deposit tenure. The initial amount compounds at a regular interval and hence, it is known as compound interest.   

How does compound interest work?

If one chooses to calculate compound interest, he/she will find that it has a significant positive influence on investments and deposits. When you invest in an instrument that compounds the principal amount, the financial institution informs you about the frequency of compounding. The frequency of compounding is essentially the interval at which the interest is calculated in a year. The frequency can be weekly, monthly, quarterly or annually. The accumulated interest will be added to the principal amount at the pre-decided frequency. If an investment, loan or deposit has an annual frequency of compounding, the total interest earned in a year will be added to the principal amount and the interest in the second year will be calculated on the new amount.

Compound Interest formula

Compound interest is an age-old concept in business and finance. One can calculate the compound interest using a simple compound interest formula. The formula for calculating compound interest is :

A = P(1+r/n)^nt.

P denotes the principal amount

r is the rate of interest per annum

n is the number of times in a year the interest gets compounded

t is the number of years

Let us understand compound interest with an example.

Let’s Understand Compound Interest Calculation With An Example

Let us assume, Jignesh invests Rs. 10,000 for 4 years at an interest rate of 10%. The investment will compound annually. In the first year, the interest will be calculated on Rs. 10,000

Amount = 10000*10/100 = 1000

Jignesh will earn Rs. 1000 in interest on his investment.

The principal amount at the start of the second year will be Rs. 11,000.

The second year, he will earn 11000*10/100, which is equal to Rs. 1100.

In the third year, the principal amount will be Rs. 10,000 + Rs. 1000 + Rs. 1100 = Rs. 12100.

The interest income in the third year will be 12100*10/100 = Rs. 1210

The principal amount at the start of the fourth year will be Rs. 13,310

The interest in the fourth year will be 13310*10/100 = Rs. 1331

The total amount at the end of four years will be Rs. 14,641

Compounding has helped Jignesh grow his money from Rs. 10,000 to Rs. 14,641 in four years. The power of compounding increases with time.

How to use a Compound Interest calculator?

Compound interest calculator is a free online tool that helps investors get an idea of the total corpus at the end of the investment tenure.

  1. A compound interest calculator asks for certain data like the initial investment amount, the monthly additions, the expected rate of return and the investment tenure to provide the value of the investment at the end of the tenure.
  2. To get the total corpus at the end of the tenure, you will have to provide the initial amount, the amount you plan to add in the initial amount and the frequency of the additions.
  3. One may wish to add a fixed amount on a month, quarterly or yearly.
  4.  A compound interest calculator also asks for the number of years one plans to add funds to the initial corpus.
  5. Additionally, one also has to provide the planned tenure of the investment.
  6. The expected rate of return along with all the other data will generate the total value of the corpus at the end of the tenure.

Benefits of compound interest

Compound interest has been called the ‘eighth wonder of the world’ by physicist Albert Einstein. There are various benefits of compound interest.

● Exponential growth:

 Compound interest can help you grow your investment exponentially. The addition of the accumulated interest in the principal amount for the calculation of interest magnifies the returns from the investment. The total corpus increases at a faster pace due to compounding.

● Regular additions:

Investment and deposit schemes that compound the initial investment provide the option to add money to the corpus at regular intervals. Regular additions help in speeding up the returns. The bigger the corpus, the higher is the interest income and the faster the investment grows.

●  Faster achievement of financial goals:

 By investing in a financial product that compounds the returns, one can achieve his/her financial goals at a faster pace. The more time the investment gets, the higher is the intensity of compounding.    

Compound Interest V/S Simple Interest: How the final amount varies

There is a substantial difference between the returns generated by compound interest and simple interest. Jignesh was able to convert Rs. 10,000 to Rs. 14,641 in four years with the help of compound interest. Let us take the same tenure and interest rate and see the growth with simple interest.

The formula of simple interest is :

 P*R*T/100

Here, P is the principal amount, R is the interest rate and T is the tenure.

The principal amount is Rs. 10,000, the interest rate is 10% per annum and tenure is 4 years.

The simple interest will be 10000*10*4/100 = 4000

The amount in four years will be Rs. 14,000. It is worth remembering that the power of compounding increases with time.

How to take advantage of compound interest?

The positive effect of compounding on investment is apparent. To take advantage of compound interest, one needs to focus on a few points.

1. Invest early and regularly:

The earlier you invest the more time your money will get for compounding. Making regular investments is equally important. It helps in offsetting the impact of market fluctuations.

2. Hold for the long-term:

It is important to hold the investment for the long term as the power of compounding increases with time. The growth in the corpus is higher in the later years as the corpus is larger.

3. Frequency of compounding:

The higher is the frequency of compounding the higher will be the interest income.

4. Higher rate of return:

One can reap rich benefits if one combines a higher rate of returns with compound interest. It is important to ensure that you choose investment options with a higher rate of return.  

What are the frequencies in which compound interest is calculated?

A compound interest calculator is a flexible tool. It includes options for

  • Daily compounding
  • Monthly compounding
  • Quarterly compounding
  • Half-yearly compounding
  • Yearly compounding

How do compounding intervals affect the interest earned?

Different investment options have different compounding intervals. When deciding between investment options, opt for the product that compounds more frequently. The shorter the compounding interval, the higher will be the growth. If there are more compounding intervals, the accumulated interest gets added to the principal amount more often, which results in a faster increase in the interest income.

Things to keep in mind while using compound interest

Compound interest is an effective tool for wealth accumulation. However, one should keep certain points in mind while using compound interest.

●  Pay-off loans early:

In the case of investments and deposits, compound interest can be a boon, but it becomes a bane in the case of loans. The longer you take to pay off a loan, the higher will be the interest burden. One should pay off a loan as early as possible as compound interest can be counterproductive.

● Focus on additions:

Compound interest can help the principal amount  grow exponentially. However, rather than watching an initial amount grow, one should focus on adding to the amount at regular intervals. The effect of compounding multiplies with additions to the initial corpus.

Compound interest terms & definitions

  • Beginning account balance: The amount of money you have saved to invest to gain from compound interest. It is the initial investment put in by an individual.
  • Additions: The amount that you add at regular intervals to the corpus is known as additions.
  • Rate of return: It is the annual interest rate that one earns on his/her investment.
  • Tenure: It is the total duration of the investment.
  • Future value: The total value of the corpus in the future. It includes the initial investment, additions and the interest earned.

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FAQs On Compound Interest

  • ✔️What is the effective annual rate?

    Effective annual rate is the actual rate of return after compounding. The effective annual rate is higher if the compounding frequency is shorter. 

  • ✔️Is the compound interest rate calculator a dynamic tool?

    Compound interest rate calculator is a dynamic tool that can help you calculate the total corpus with changing variables. One can easily change the rate of interest, the value of additions and the tenure to get the exact results.

  • ✔️How many times can I use the compound interest calculator?

    There are no limits on the usage of the calculator. One can use it as many times as one requires. The variables can also be changed to get a comprehensive view of an investment, deposit or loan.

  • ✔️Who benefits from compound interest?

    Investors who stay invested for longer durations can benefit from compound interest. The money grows at a faster rate in compounding than simple interest 

  • ✔️Is it better to compound monthly or daily?

    The frequency of compounding periods makes a major difference while calculating compound interest. The higher the number of compounding periods, the greater the amount of compound interest.

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