Compounding: What is Really is ?
Basically, compounding takes place when your earnings grow exponentially as you earn interest on your investment (principal amount and interest) as time passes. The possibilities of the power of compounding are endless, as the investment generates the ability to earn. Also, compound interest only further enhances your earnings time passes and lets your investment grow manifold. Let’s understand what is compound interest and the use of the compound interest calculator in detail.
What is Compound Interest?
Simply put, when interest is added to the principal amount of an investment, loan or deposit, it is known as compound interest. It is called so because the accumulated interest is added to the principal amount and the interest for the upcoming period is calculated on the new amount, which is the principal amount plus the amount of the accumulated interest over the prior period. This process is repeated throughout the investment’s tenure. So basically, the interest is calculated on the compounding of the principal amount and the interest generated previously. The power of compounding lies in the fact that it essentially increases the investment amount every year by factoring in the interest amount generated earlier, thus, giving it a definite edge over simple interest.
How to calculate compound interest?
The formula for calculating compound interest is A = P (1 + r/n) ^ nt
For this formula, P is the principal amount, r is the rate of interest per annum, n denotes the number of times in a year the interest gets compounded, and t denotes the number of years.
In order to understand this better, let us take the help of an example:
Sania made an investment of Rs 50,000, with an annual interest rate of 10% for a time frame of five years. With compound interest calculated on it, the interest for the initial year will be calculated on the below mentioned basis: 50,000 x 10/100 = Rs. 5,000
Similarly, the interest for Sania’s second year will be calculated on the accumulated amount, i.e: 50,000 + 5000 = 55,000
Hence, the interest for the second year will be calculated on this basis: 55,000 (which is 50,000 plus 5,000) x 10/100 = Rs. 5,550
Similarly, the interest for the third year will be calculated on this basis: 50,000+5,000+5,550 = Rs. 60,550*10/100 = Rs. 6055
Moving forward with a similar calculation, the interest for the fourth year for Sania’s initial investment of Rs 50,000 will be calculated on this basis:
50,000+5,000+5,550+6055 = Rs. 66,605 *10/100 = 6,660.5
The final interest for the fifth year will be
50,000+5,000+5,550+6055+6,660.5 = Rs. 73265.5*10/100 = Rs. 7,326.55
Thus, we see that with the power of compounding, Sania has earned a substantial interest of
5,000 + 5,550 + 6055 + 6,660 + 7,326.55= Rs 30,591.55
Hence, Sania’s total investment after a period of five years has amounted to
Rs 50,000 + Rs 30,591.55 = Rs 80,591.55
Compound Interest V/S Simple Interest: How the final amount varies
With the help of the compound interest formula and calculator, we see that the interest that Sania has earned on her initial investment is quite substantial. However, what if her investment would have earned simple interest? Let us see how different the scenario would have been if simple interest would have been calculated on her investment:
The formula for calculating simple interest is: P * R * T / 100.
Here P denotes the principal amount, R is the interest rate and T is the time frame.
For Sania’s investment of Rs 50,000, the interest will be calculated on this basis:
Rs 50,000*10*5/100 = Rs 25,000
The total investment amount would have come in at Rs 50,000 + Rs 25,000 = Rs 75,000
Through this simple example, we see that the final return will be higher if the interest calculated is compounded.
Calculating compound interest charged on borrowings
With the help of the compound interest calculator, you can not only calculate the interest on an annual basis, but also make calculation for various time frames such as those charged on your borrowings or credit card. Here is an example of how compound interest will affect your daily borrowing:
Let us again take the example of Sania here. She has borrowed a sum of Rs 50,000 at a daily compound interest rate of 10% for a period of five years.
The amount will be calculated on the basis of this formula:
Principal (1+rate/365) 365*time – Principal (here, 365 is the number of times it is compounded a year)
Hence, the interest can be arrived at by the following calculation:
50,000 (1+10/100*365) 5*365-50000
= 50,000 (1+10/100*365) 5*365 – 50,000
= 50,000 * 1.649 – 50,000
= 32,450
From the above calculation we see that for a period of five years, the daily compounded amount is: Rs. 32,450. Therefore, the total repayable amount will be Rs 50,000+ 32,450 = Rs 82,450
Facts about compound interest that you should know
- If you want an estimation of how much your investment will yield, you can always click on our compound interest calculator for an accurate estimate.
- Our online compound interest calculator is customized so that you can make inputs as per your own requirements. So you have the ease of choosing the amount or the rate of the interest as you are charged and calculate your interest accordingly.
- While compound interest is great when you are investing and making daily savings, it can get quite expensive when you are charged compound interest. This can get really tricky especially if you have a credit card. If you let your bills mount, you have to pay a really hefty bill, owing to the high interest rates. So be careful with your payments and do not let your bills mount.
- The potential of compound interest is enormous. If you make an investment which generates a compound interest of 6% per year, it will double in a 12-year period while it has the potential to grow fourfold in 24 years.
- While initially, it might seem to you that the sum earned is nothing significant, even if you earn an interest of 5% which is compounded each month, you will stack up an impressive amount after 10 years, even without adding anything extra to it!
- The best part about the beauty of compound interest is that you do not have to be a financial analyst to understand how to earn it. If you invest wisely and make little sacrifices by depositing money in your savings account, it will ultimately add up. Also, remember that when you are investing, it is better if the amount compounds quarterly instead of annually, for the best benefits.
- In India, the Ministry of Finance has taken the decision to annualise the compound interest for the National Saving Certificate( NSC) for 10 year and 5 year periods. This has become applicable from April 1, 2016. Alongside it, the government has taken the decision to slash interest rates on post office schemes for the short term. This measure has been taken to keep the interest rates in sync with the market rates.
Now that you understand the significance of compound interest and how it is calculated, you can use the compound interest calculator to know how much you are earning on your investments or even to know how much your credit card company will charge you for your outstanding bill. So if you haven’t already started investing, it is time you did to capitalize on the power of compounding to enhance your wealth!
