Contents
Simple interest and compound interest – these are the two methods of calculating interest charged on the loans taken, a deposit made in a bank, etc. Well, no matter whether you borrow funds from a bank or Non-Banking Financial Company(NBFC), the interest charge is always attached. So, the borrower needs to know simple and compound interest to make a sound decision. In this blog, we will be discussing the concept of compound interest, compound interest calculator, how it works, and the difference between compound interest and simple interest.
Compound interest is the calculation of interest where the interest amount is added along with the principal amount. This means, all the previous interest paid or earned will be taken into consideration while calculating next time. The Compound interest calculator helps in checking the final amount you will be getting after the completion of the tenure of the plan.
How Compound Interest Works
Simple interest is a set percentage paid on the initial principal. If you borrowed Rs.1,000 and agreed to pay it back three years later at 20% annual interest, you would owe Rs.600 interest plus the Rs.1,000 principal you borrowed.
If you had an Rs.1,000 loan with interest that compounded 20% annually, you would owe 20% on the annual balance, which would increase every year. After three years, you would owe Rs.1,728 — Rs.1,000 in principal and Rs.728 in interest because every year the previous year’s interest is added to the principal.
Most loans don’t compound annually but instead use a daily, weekly or monthly increment. If it is a debt, the amount you owe also will increase more rapidly. More frequent compounding means your money will grow more quickly if it is in a bank account with compound interest charged on it.
Advantage of Compound Interest
- Save Early and Often: When growing your savings, time is your friend. It takes a while to get momentum. The momentum will build and eventually gain strength. Be patient, leave your money alone, and think long term.
- Check the APY(Annual Percentage Yield): To compare bank products such as savings accounts, look at the APY. It takes compounding into account and provides a true annual rate. It’s easy to find because banks typically publicize the APY since it’s higher than the interest rate.
- Keep Borrowing Rates Low: In addition to affecting your monthly payment, the interest rates on your loans determine how quickly your debt grows, and the time it takes to pay it off. It’s difficult to pay off double-digit rates.
The disadvantage of Compound Interest
The advantages are disadvantages as well when you have to pay for it. The disadvantage is that if the interest charged on credit cards is compounded then it could be a burden on the card holder. The interest charged to outstanding balances can be very high. Also, unless you read the small print you aren’t going to be prepared for the way interest is charged on your card. For example, if you move a balance across from one card to another that transfer will be at a very low rate. But if you go out and purchase something else with that same card the new purchase will be at a very high rate and the burden of interest won’t ever shift off you until you pay all the bills of the credit card.
How to calculate
Compound interest is calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods raise by no of compound periods multiply no of years.
The formula for calculating compound interest is:
= A = P (1 + r/n) ^ nt
(Where 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.)
Examples-
An amount of Rs.1,500 is deposited in a bank paying an annual interest rate of 4.3%, compounded quarterly. What is the balance after 6 years?
Using the compound interest formula, we have that
P(Principal) = 1500,
r(rate of interest) = 4.3/100 = 0.043,
n(no of times in a year the interest is being compounded) = 4,
t(no of years) = 6.
Therefore,
| Year | Interest | Principal | formula | Final Amount |
|---|---|---|---|---|
| 1 | 4.3% | 1500 | 1500(1+0.043/4)^4*1 | 1564 |
| 2 | 4.3% | 1564 | 1564(1+0.043/4)^4*2 | 1631 |
| 3 | 4.3% | 1631 | 1631(1+0.043/4)^4*3 | 1701 |
| 4 | 4.3% | 1701 | 1701(1+0.043/4)^4*4 | 1774 |
| 5 | 4.3% | 1774 | 1774(1+0.043/4)^4*5 | 1850 |
| 5 | 4.3% | 1850 | 1850(1+0.043/4)^4*6 | 1929.56 |
So, the balance after 6 years is approximately Rs.1,929.56.
Example 2-
If you have a bank account whose principal = Rs.2000, and your bank compounds the interest twice a year at an interest rate of 10%, how much money do you have in your account at the year’s end?
P(Principal) = 2000,
r(rate of interest) = 10/100 = 0.10,
n(no of times in a year the interest is being compounded) = 2,
t(no of years) = 1.
A(Amount)= 2000(1+ 0.10/2)^2*1
| Year | Interest | Principal | Formula | Final Amount |
|---|---|---|---|---|
| 1 | 10% | 2000 | 2000(1+ 0.10/2)^2*1 | 2205 |
So, the balance after a year is approximately Rs.2205.
Compounding Periods
To estimate compound interest, it is important to take into account the number of compounding periods. They can make a huge difference to the accrued money. More the number of compounding periods in the investment period, the corpus amount also increases accordingly. This is because interest is calculated at the end of each period. It could be on a monthly or weekly or quarterly or annual basis. For instance, if you invest Rs. 100,000 for 5 years and compounds every year, you will earn more compared to having it compounded for 2/3 years. The Compound interest calculator calculates the amount which you will get on completion of your investment plan tenure.
Rule 72
Rule 72 is used to calculate the number of years one has to wait for his investment options to be double what it is today. By dividing 72 with the rate of interest, you can get the estimated number of years required to double the original investment.
Example- 72/12% = 6 Years, It would require 6 years to double your original investment if the rate of interest is compounded annually.
Power of Compounding
To tap the power of compounding, you need to invest in any scheme that follows the compound interest system like a mutual fund (Growth) or saving scheme, and then let it be. As they generate interest or dividends, the profits get reinvested and compound the earnings at a fast-tracked rate.
Here, interest rates can make a huge difference. If the investment is more on the risky side, the scope for higher gains also increases. For example, a savings account gives less interest, but investing in a mutual fund investment can earn you supreme returns over a longer tenure. Compounding is highly recommended because it can beat inflation. For instance, if your capital is making 3% interest and the inflation rate is 4%, you will face a 1% loss.
In short, it is not just important to invest, but also to explore ways to get the most out of it. You can visit WealthBucket site for selecting the best Mutual Fund that can get you good returns.
Compound Interest vs Simple Interest
| Basis of Comparison | Simple Interest | Compound Interest |
|---|---|---|
| Meaning | Simple Interest refers to an interest that is calculated as a percentage of the principal amount. | Compound Interest refers to an interest that is calculated as a percentage of the principal and accrued interest. |
| Return | Less | Comparatively High |
| Principal | Constant | Goes on changing during the entire borrowing period. |
| Growth | Remains uniform | Increases rapidly |
| Interest charged on | Principal | Principal + Accumulated Interest |
Difference between Simple Interest & Compound Interest with example
| Principal Amount | Year | Simple Interest | Compound Interest | Final Amount(Simple Interest) | Final Amount(Compound Interest) |
|---|---|---|---|---|---|
| 1000 | 1 | 1000 X 20%=200 | 1000 X 20%=200 | 1200 | 1200 |
| 1000 | 2 | 1000 X 20%=200 | 1200 X 20%=240 | 1400 | 1440 |
| 1000 | 3 | 1000 X 20%=200 | 1440 X 20%=288 | 1600 | 1728 |
Conclusion
Compound interest helps one to reach their long term goals. Time is a huge factor that can increase the benefit of compound interest so one should be patient.
This blog on the compound interest calculator is for your knowledge to make you aware of the power compounding, rule 72 and the difference between the simple interest and compound interest calculator.
Our company WealthBucket is a CA/CS Firm providing various services related to Mutual Funds like investing in Large Cap Mutual funds, Equity Funds, Debt Funds, etc.
You can contact us on +91 9999379929 or you can mail your queries on our mail contact@wealthbucket.in.
Related Articles :
Expense Ratio: Types, components, Limit be SEBI
