The power of compounding can bring wonders in your savings or deposits once you figure out how it is calculated. It may happen that when you visit a bank to open a, per se fixed deposit account, the banker may inform you about the prevailing rate of interest applicable on the principal deposit, and may also add that the compound interest will be calculated on a quarterly or monthly frequency. “What is compound interest?” – you may ask.
In compound interest, the interest on the principal amount on the deposit is added upon previously accrued interest. In simple terms, compound interest is the interest you earn on interest, which gets calculated on a daily, weekly, monthly, quarterly, half yearly, or annual frequency depending on the financial institution.
For example, your deposit of INR 10,000 for a tenure of two years earning 5% interest per annum that gets compounded annually can help you earn INR 500 interest in the first year. In the second year, however, your principal amount of INR 10,500 will get you additional INR 525 as interest, helping you earn a total of INR 11,025 in two years.
Understanding Compound Interest
Compound interest is generally used in calculating returns on savings accounts, fixed deposits, recurring deposits, as well as bonds, mutual funds, dividend stocks and real estate investments. To calculate compound interest, you first need to know:
Principal amount (initial deposit): The amount you want to deposit in a savings instrument, either on a recurring or lump-sum basis.
Recurring contribution: If you choose to make a deposit on a recurring basis, either monthly, quarterly or annually.
Investment tenure: How long do you want to stay invested?
Rate of interest: The interest rate applicable on the principal amount.
Compounding frequency: How often does the financial institution compound interest (daily, weekly, monthly, quarterly, half-yearly or annually)?
Formula to Calculate Compound Interest
Once you’ve understood what is required to calculate compound interest on deposit, then the following formula is used to calculate the compound interest:
A = P (1+r/n)nt
A = Final amount
P = Principal amount
r = The rate of interest
n = Number of times interest gets compounded
t= Tenure
Annual Compounding Example: Say, X has invested INR 5 lakh in a fixed deposit and stays invested for five years and earns 5% interest per annum that gets compounded annually.
Compound Interest = P (1+r/n)nt
A = Final amount
P = INR 5,00,000
r = 0.05 (or, 5%)
n = 1
t = 5
nt = 5 (1*5)
A = 5,00,000 (1 + 0.05/1)5 = INR 6,38,141
Therefore, X’s investment of INR 5 lakh in five years compounded annually will grow to INR 6.38 lakh at 5% rate of interest per annum.
Quarterly Compounding Example: Say, Y has invested INR 5 lakh in a fixed deposit and stays invested for five years and earns 5% interest that gets compounded quarterly.
Compound Interest = P (1+r/n)nt
A = Final amount
P = INR 5,00,000
r = 0.05
n = 4
t = 5
nt = 20 (5*4)
A = 5,00,000 (1 + 0.05/4)20 = INR 6,41,018
Therefore, Y’s investment of INR 5 lakh in five years compounded quarterly will grow to INR 6.41 lakh at 5% rate of interest per annum.
Monthly Compounding Example: Say, Z has invested INR 5 lakh in a fixed deposit and stays invested for five years and earns 5% interest that gets compounded monthly.
Compound Interest = P (1+r/n)nt
A = Final amount
P = INR 5,00,000
r = 0.05
n = 12
t = 5
nt = 60 (5*12)
A = 5,00,000 (1 + 0.05/12)60 = INR 6,41,680
Therefore, Z’s investment of INR 5 lakh in five years compounded monthly will grow to INR 6.42 lakh at 5% rate of interest per annum.
Simple Interest Formula
To calculate simple interest, the formula in use is:
A = P (1 + rt)
A = Final amount
P = Principal amount
r = rate of interest
t = tenure
Simple Interest Example: Say, X has invested INR 5 lakh in a certain deposit and stays invested for five years and earns 5% interest per annum.
A = P (1 + rt)
A = 5,00,000 (1 + [.05 * 5])
A = 5,00,000 (1 + .25)
A = 5,00,000 (1.25)
A = 6,25,000
Therefore, X’s investment of INR 5 lakh in five years will grow to INR 6.25 lakh at 5% rate of interest per annum using the simple interest formula. However, if the interest was compounded, X would have earned more using the compound interest formula, like the ones mentioned above.
Benefits of Compound Interest
Grow your wealth faster
Compound interest helps you generate wealth at a faster rate as the interest on the principal amount is added upon previously accrued interest unlike simple interest, where interest is calculated only on the principal amount.
Benefit from frequent compounding
As per your savings deposit and interest rate, the more frequently an account compounds interest, the more you’ll earn.
Earn more interest on principal amount
Investors prefer compound interest as the total interest earned on the deposit is relatively higher.
Power of compounding
Compound interest allows investors’ annual returns to keep increasing thus helping them generate extra wealth.
Bottom Line
Compound interest can, however, hurt your personal finance when you have to pay it, especially while availing loans and credit cards. This means, you may end up paying interest upon interest. Lenders usually charge compound interest rates in the form of annual percentage rate (APR).
Related: APR Vs Interest Rate: What’s The Difference?
Frequently Asked Questions (FAQs)
Is compound interest better than simple interest?
Yes – Unlike simple interest, where interest is calculated only on the principal amount, compound interest helps you generate wealth at a faster rate as the interest on the principal amount is added upon previously accrued interest
