Principle Amount

₹ 1000

₹ 1,00,00,000

Rate of Interest (p.a)

1%

30%

Time Period (in years)

1 yr

30 yrs

Compound interest in simple terms means the 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. The 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.

Albert Einstein rightly said “Compound interest is the 8th wonder of the world. He who understands it earns it and he who doesn’t pay it.” Compounding is a very powerful concept. This is because the interest of your invested money is also earning interest. The value of the investment keeps growing at a geometric rate (always increasing) than at an arithmetic rate (straight-line). Your money keeps on multiplying over a period of time. Also, if paying interest is ignored or if there is any delay in paying the loan then the interest burden will surely be high. Also, to take advantage of compounding one has to increase the frequency of loan payments. This way they can pay lesser interest than what they are liable to pay.

Investing in mutual funds or stocks is the best way to compound your wealth over a period of time.

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]

P is principal, I is the interest rate, and n is a number of compounding periods.

For example, An investment of Rs 1,00,000 for 5 years at a 12% rate of return compounded annually is worth Rs 1,76,234.

Power of Compounding

To realise that the power of compounding works in your favour when you earn compound interest, but not when you’re the one paying it. To that point, you can leverage the power of compounding by investing in a range of assets, including mutual funds, fixed deposits, or even PPF.

For instance, consider an equity mutual fund investment worth ₹1,00,000 per annum. Assuming it returns 10% p.a., your investment will grow to the following amounts over different periods:

Period (years) | Invested Amount | Value of Investment |
---|---|---|

1 | ₹1,00,000 | ₹1,10,000 |

5 | ₹5,00,000 | ₹6,71,561 |

10 | ₹10,00,000 | ₹17,53,116 |

15 | ₹15,00,000 | ₹34,94,973 |

20 | ₹20,00,000 | ₹63,00,250 |

Over 20 years, your value of an investment will more than triple vis a vis the invested amount — and that’s the power of compounding.

- Dhan’s compound interest calculator helps you calculate the compound interest you’ll earn on your investment with a single click.
- Dhan’s compound interest calculator can help you assess how compound interest can grow your money faster than simple interest.
- The Dhan’s compound interest calculator enables you to calculate the interest by taking into consideration the invested amount and the interest earned on it, while the simple interest calculator simply calculates interest on the invested amount.

The conceptual difference between simple interest and compound interest lies in the amount on which the interest is earned. However, there are several other differences between them.

Differentiating Point | Simple Interest | Compound Interest |
---|---|---|

Amount on which interest is earned | Simple interest is earned only on the invested amount (principal). | Compound interest is earned on the invested amount (principal) as well as the interest earned on it. |

More Returns Under Which Method | The total interest earned is lower with simple interest as compared with compound interest. | The total interest earned is relatively higher than compound interest and therefore favorable for investors. |

Computation | Simple interest formula: (P x R x T) ÷ 100 |
Compound interest formula: [P x {1+(R/n)}N] - P |

We’ve seen how compound interest has a dramatic positive effect on investments. One needs to know how to take advantage of this. Here are a few ways one can take advantage of compound interest.

Investing early and regularly: Invest early. This will ensure that your money is earning at its full potential. Also, investing regularly is as important as investing early. Investing regularly will help in avoiding the timing of the market. By investing small amounts regularly one can accumulate large amounts.

Hold your investment for a long term: Holding the investments for a long will help earn interest for a longer period. Holding for a long period is very important because compounding works only in the long term.

Frequency of compounding intervals: The more the frequency of compounding, the larger the interest earned. Choose investments that pay interest more frequently than the ones which pay less frequently.

Higher rates of return: Only a high return investment can earn you more money. Make sure that you pick up investment options with higher rates of return. Like mutual funds. Only then one can reap the full benefits of compounding.

Increase the frequency of loan payments: By increasing the frequency of loan payments one can reduce the interest burden. Try paying one or two months of extra EMIs in a year to reduce the total interest paid on loans taken.

In compound interest, the investment grows much faster than the simple interest as the interest is paid on both investments 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 You can see it yourself that there is a great difference in the returns between the two. Therefore, compound interest proves to be a good option for investment the return is higher than simple interest.