An often-repeated quote, usually attributed to German-born theoretical physicist Albert Einstein, goes like this: Compound Interest is the world’s eighth wonder. He who understands it, earns it. He who does not, pays it.In the financial world, especially for investors, Compound Interest is significant. It shows why even investing small amounts from a young age pays long-term.
So, let us understand what Compound Interestis and how to calculate it. The interest accrues not just on the initial principal Loan or deposit but also the accumulated interest from previous periods. It is often used when interest earned gets reinvested. Using the Compound Interest calculator, you can check how much interest you accrue. The formula is:
A = P(1+r/n)nt
A is the final amount
P is the original principal sum
r is the annual interest rate
n is the compounding frequency (monthly, quarterly, etc.)
t is the length of time in years
If you want to calculate just the interest part, then subtract the principal from the final amount as follows:
Compound interest (CI) = P(1+r/n)nt – P
Once the formula is clear, you can calculate Compound Interest easily. Let us understand with an example. We will calculate what interest you will getat maturity if you invest Rs. 1 lakh today in Bank Fixed Deposit for two years. We will assume you have chosen an option that compounds quarterly. The current interest rate is 5% per annum.
In this example,
P = 1,00,000
r = 5% (or 5/100)
t = 2
n = 4 (number of quarters in a year)
On inputting these values in the formula, we get;
CI = 1,00,000(1+0.05/4)4×2– 1,00,000 = 110,448.61 – 1,00,000 = 10,448.61
The compounded interest is Rs. 10,448.61.
Difference between SI and CI
It is fundamentally different from simple interest on one parameter. Here, you do not calculate accumulated interest from the previous period. For instance, considering the mentioned example, if you choose an option that gives simple interest at 5% per year at the time of maturity, the interest amount would be Rs. 10,000. You will be at a loss of around Rs. 450, or about one-third of the total interest payout.
Benefits of compounding
They are best visible when you invest long-term. The longer the term, the more the benefit. Let us understand with another example.
You and your friend invested Rs. 1 lakh in an instrument that matures in 2030, promising a 5% per annum yield. Both of you plan to reinvest any interest that gets paid out. However, there is one difference: you started your investment early, in 2000, and your friend in 2010. The payout at the maturity that both of you get are:
Payout to you: Rs 4,32,194.24
Payout to your friend: Rs 2,65,329.77
Both invested the same amount but 10 years apart,and the difference is a staggering Rs. 1.66 lakh. To ensure both of you get an equal payout in 2030, your friend should have invested about Rs. 1.63 lakh in 2010. This calculation gets done quickly over the Compound Interest calculator.
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