What Is Compound Interest And Why It Is Important All You Need To Know?
Compound interest is sometimes also referred to as “the eighth wonder of the world.” There is a strong reason behind saying this. A famous proverb “money makes money” is true in the case of compound interest. Investing your money on a compounding interest earns you more money. You not only get the interest amount on the sum invested by you initially but also on the previously earned interest. Sounds interesting? Continue reading to deep dive into everything related to compound interest and how investing in compounding interest adds value to your wealth.
Understanding Compound Interest.
You receive an interest amount when you deposit money into your savings account. You receive this interest at the same rate each year. This is simple interest. Every year, it is calculated on the initial investment amount.
Imagine, however, that you also receive interest on the principal amount and the interest from prior years. Sounds intriguing, yes? It happens in the case of Compound interest. “Compound” is when two or more things are combined. What you are combining in this instance is “Interest.”
To put it simply, Compound interest is just a combined interest. In other words, it occurs when interest is paid on top of interest. Compounding interest is the simplest and quickest approach to increasing your investment amount.
Components of Compound Interest.
There are four main components of compound interest. Take a look at each one of them in detail.
- Principal.
The principal is also known as the initial investment. It is an amount that you invest in the very beginning for say, in your savings account in a bank. The principal is the basis of the first year’s interest.
- Interest Rate.
It is a rate at which interest is calculated. It remains the same throughout the investment tenure—however, the principle for calculating interest changes. Every year the interest rate applies on a variable sum (principal plus interest from previous periods).
- Compounding Frequency.
It is the number of times you get interest amount in a year. The compounding frequency occurs yearly, half-yearly, quarterly, and monthly. The interest rate depends on compounding frequency. The higher the compounding frequency, the lower the interest rate.
- Tenure.
It is the period in which an investment sustains. It has a direct impact on the interest amount and final amount. The higher the tenure, the higher the interest earned and the higher the final amount received.
It is the most important component as it allows an investor to predict the future profitability of the investment. An investment with a low-interest rate and low compounding frequency is still attractive with long tenure.
Practical Example of Compound Interest.
To understand better let’s take a practical example of an investment of Rs 1,00,000. The interest rate is 10% compounded yearly. And the tenure for the investment is 3 years.
The table below shows the calculation of
- Principal sum (subject to change every year),
- Interest earned, and
- The final amount(Principal plus interest).
| Year. | Principal Sum. | Interest Rate. | Interest Earned. | Final Amount. |
| 1st | 1,00,000 | 10% | 10,000 | 1,10,000 |
| 2nd | 1,10,000 | 10% | 11,000 | 1,21,000 |
| 3rd | 1,21,000 | 10% | 12,100 | 1,33,100 |
| Total | – | – | 33,100 | – |
The formula of Compound Interest Calculation.
The basic formula to calculate compound interest without doing manual calculations is
A = P(1+r/n) ^ nt
Here,
A represents the final amount at the end of the tenure.
P represents the Principal Sum or initial investment.
r represents the compounding rate of interest.
n represents compounding frequency per year.
t represents the number of years in the tenure.
Let’s now take the same example as the previous one. Say,
P = 1,00,000
r = 10%
n = 1
t = 3 years
The Final Amount at the end of the tenure using the formula of compound interest will be
A = 100000(1+0.10/1)^1*3
A = Rs. 1,33,100
The interest earned over the years is 33,100.
Why is Compound Interest important?
Compound interest causes your wealth to grow faster. Because you will receive returns on both the money you invest and returns after each compounding period. It causes a sum of money to increase more quickly than with simple interest. As a result, you will not need to save much money to accomplish your goals. Additionally, it’s essential for assisting in the mitigation of wealth-depleting causes like rising living expenses, inflation, and declining purchasing power.
When accumulating wealth, the power of compounding can be crucial. Let’s understand this with the help of an example. The amount of compounded interest increases with the number of compounding frequencies. Consider it like a snowball. The sooner you start investing, and the more money you put into it, the bigger your snowball gets. Consider what would happen if you push the snowball down a slope covered in snow.
Now that you’ve packed additional snow, it will remain and you’ll continue to do so. Your snowball will eventually contain the snow you started with, the snow it picked up along the way, and even more snow on top of that when it reaches the bottom of the hill. This is how compound interest works and plays an important role.
In a nutshell
Investing your money in compound interest gives you exciting returns on your investment. All you need to do is make early investments and earn returns for a long period. Through the returns earned you can beat real-life challenges like increasing living expenses, inflation, etc. To find more such useful and informative blogs head to our website.