What is compound interest?
Compound interest is the interest rate on a loan or deposit that is based on both the initial principal and the total interest from previous periods.
It is basically ‘interest earned on money that was previously earned as interest’.
This allows your sum and interest to grow at a faster rate compared to the simple interest which is calculated only on the principal amount.
The rate at which compound interest accumulates interest depends on the frequency – higher the number of compounding periods, higher will be the compound interest.
For instance, if you earn a 10% annual interest, a deposit of $100 would gain you $10 after a year.
What happens in the following years?
This is where compound interest comes into play. You get interest on your deposit and also interest on the interest you just earned.
The longer you leave your money untouched, the more it grows because compound interest increases over time, which means your money multiplies over time.
If you are repaying a loan with compound interest, you should not miss the interest payment, otherwise a delay in repaying the loan will result in high interest.
To take advantage of compounding, you should aim to increase the frequency of loan repayments. This way you can pay less interest than you have to pay.
Because the interest effect on interest can generate positive returns depending on the initial amount of principal, it sometimes referred as the snowball effect of compound interest.
How does Compound interest works?
If you make a proper investment, compound interest can help you to build your wealth over time. But if your debt is subjected to compound interest, then it can cause financial hardship if not planned. To understand how compound interest works, let us break down the process of how your investment can compound better.
Compound Interest starts when your investment earns interest. At this point, the interest is added to the initial investment amount. When it earns interest again, it will determine the newly earned interest by calculating the initial capital invested and the earned interest.
As the size of the investment continues to grow, it will earn interest to the total investment amount. This loop will continue allowing the investment to grow substantially without any additional investment capital. With time, this cycle has potential for a substantial growth of the original investment.
The following two elements will affect your compound interest investment:
Time – You need to allow your investments to grow with time, the more time you enable, the more growth you will see.
The rate of interest – A higher rate of interest will generate higher balance when compounding the investment.
Compound Interest Calculation: –
You can calculate compound interest with a simple formula. It is calculated by multiplying the first principal amount by one and adding the annual interest rate raised to the number of compound periods subtract one.
The total initial amount of your loan is then subtracted from the resulting value.
Compound Interest = Total amount of Principal and Interest in future (or Future Value) less Principal amount at present (or Present Value)
Compound Interest = P [(1 + i) n – 1]
P is principal, I is the interest rate, n is the number of compounding periods.
An investment of $ 1,00,000 at a 12% rate of return for 5 years compounded annually will be $ 1,76,234. From the graph below, we can see how an investment of $ 1,00,000 has grown in 5 years.
In compound interest, one earns interest on interest. Therefore, it already takes into consideration all the previous interests. And interest is paid on that.
Year | Investment($) | Interest($) |
1 | $ 1,00,000 | $ 12,000 |
2 | $ 1,12,000 | $ 13,440 |
3 | $ 1,25,440 | $ 15,052.8 |
4 | $ 1,40,492.8 | $ 16,859.14 |
5 | $ 1,57,351.9 | $ 18,882.2 |
Total | $ 1,76,234 |
By understanding how compound interest works and acting on it by investing in the right set of investments, you can achieve high returns.
What is the basic form of compound interest?
Compound interest is a way of calculating how your money can grow over time. It takes into account not only the initial amount of money you have (called the principal) but also the interest that accumulates on that money over time.
The basic formula for compound interest is:
A = P(1 + r/n)^(nt)
Where:
A = the total amount of money you will have in the future, including the interest
P = the initial amount of money you have (the principal)
r = the annual interest rate (expressed as a decimal)
n = the number of times interest is added per year
t = the number of years your money will be invested or borrowed for
The important thing to understand is that compound interest allows your money to grow faster because you earn interest not only on the initial amount but also on the interest that has already been added. The more often the interest is compounded, the faster your money will grow.
Compound interest vs Simple interest
With simple interest, you earn interest only on the money you deposit, not on the interest your money earns.
Let’s say you put $2,000 into an account with a simple interest rate of 2%. At the end of one year, you would earn $40 in interest if you didn’t add or take out any money. That’s because 2% of $2,000 is $40.
Most savings accounts — high-yield savings accounts, money markets, and certificates of deposit — earn compound interest, helping your assets grow faster. With compound interest, you earn interest on all the money in your account, including earned interest.
Using those same figures from above, if you added $2,000 to a savings account with an interest rate of 2% that compounds monthly, you would earn $40.37 in interest at the end of one year, or $0.37 more than with simple interest. An extra $0.37 probably doesn’t seem like much, but at the end of five years, you would earn $210.16 in interest, or $10.16 more than from simple interest.
Savings accounts typically compound daily or monthly. That means interest will be calculated and added to the account every day or every month. The more often interest compounds, the more interest you earn.
Try this calculator for any other amounts.
Advantages of Compound interest?
If you are concerned about not being able to save enough for your child’s education or retirement, then why not pick an investment avenue with compound interest?
It has the potential to grow your wealth and anyone can take advantage of the many benefits as listed below.
You can earn interest on both the money you have saved and, on the interest, that money earns.
For instance, If you invest $500 and receive 5% annual compound interest, at the end of the year you will have $525 in your account. In your second year, interest will be calculated on $525 and with every passing year, the amount accumulated will have the interest paid on the balance and grow your wealth.
The longer money sits in a compound interest account, the more benefit you will reap over the long term. A difference of even 1% in the interest rate will increase your capital gains.
With inflation, the costs of services and goods increase gradually and causes the purchasing power of currency to decline. Putting cash in investment avenues with compound interest can mitigate the negative effects of inflation.
If you are unable to manage cash well, you won’t be able to stay afloat. You need cash to fund your daily needs and to plan for long term goals.
Hence, investing money in compounding interest accounts can be a good source for long-term cash management plan.
