What is Compound Interest ?
Compound interest is the interest calculated on the principal and the interest accumulated over the previous period. It is different from simple interest, where interest is not added to the principal while calculating the interest during the next period. In Mathematics, compound interest is usually denoted by C.I.
Compound interest finds its usage in most of the transactions in the banking and finance sectors and other areas. Some of its applications are:
- Increase or decrease in population.
- The growth of bacteria.
- Rise or Depreciation in the value of an item.
- Compound interest in simple terms means interest on interest. When the principal includes the accumulated interest of the previous periods and interest is calculated on this then they say it’s compound interest. Compounding is done on loans, deposits and investments.
- Frequency of compounding is basically the number of times the interest is calculated in a year. Daily, weekly, monthly, quarterly, half-yearly and annually are the most common compounding frequencies.
- The higher the frequency of compounding, the greater the amount of compound interest. The frequency of compounding depends on the instrument. A credit card loan is usually compounded monthly and a savings bank account is compounded daily.
How to calculate compound interest?
Compound interest can be calculated with a simple formula.
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]
Where P is principal,
I is interest rate,
n is number of compounding periods.
Frequency of Compound Interest Calculation
The compound interest calculator includes options for :
- Daily compounding
- Monthly compounding
- Quarterly compounding
- Half yearly compounding
- Yearly compounding
Why is compound interest better than simple interest?
In compound interest, the investment grows much faster than the simple interest as the interest is paid on both investment as well as previous interest.
Let’s take an example:
Assume an investment of Rs 1 lakh is made. Let us see what would be the return with an option of simple and compound interest, given the rate of interest is 20% annually for a period of 3 years.
The simple interest earned will be I= P*R*T/100
That is, I = 1,00,000*20*3/100 = Rs. 60,000
And in case of compound interest, amount is P (1 + r/n) ^ nt
That is,
A =1,00,000(1+0.2) ^3
= 1,00,000(1.728)
= 1,72,800
Hence, I = A-P i.e. 1,72,800-1,00,000
= Rs 72,800
Therefore, compound interest proves to be a good option for investment the return is higher than simple interest.
Conclusion
In conclusion, compound interest is a powerful financial concept that emphasizes the importance of time and reinvestment in wealth accumulation. Unlike simple interest, which is calculated only on the principal amount, compound interest allows investors to earn returns not only on their initial investment but also on the interest that accumulates over time. This exponential growth can significantly enhance savings and investments, making it a critical factor in financial planning. Understanding compound interest encourages individuals to start saving early, remain consistent in their contributions, and take advantage of the compounding effect to achieve long-term financial goals.
