Easy Guide to Compound Interest: Definition, Examples and Applications

You will come across the term compound interest in various financial facets and investments. Starting from savings accounts to loans and fixed deposits, it is a common term. With it, your money can grow much faster and you can build wealth quickly. 

Similarly, when your loan interest compounds, your outstanding debt can quickly become larger. It is essential to understand what is compound interest to explore investment options and make informed decisions.

Guide to Compounding Interest

Compound interest is a type of interest with which you can earn an escalated return compared to simple interests. With compounding interest methods, you can earn interest on the original sum of money and the interest accumulates over the previously earned amount.

How Does Compound Interest Work?

Compound interest works on the capital amount as well as the interest earned over the previous period. To break it down, you need to know what these are:

• Principal Balance: The amount you invest initially
• Interest: The interest rate applied to your principal amount
• Compounding Frequency: This shows how often your interest will be compounded (monthly, quarterly, annually or daily)
• Duration: The duration over which your funds attract interest

With the power of compounding, your principal grows every month/year as it earns interest. This new sum earns more interest unless you withdraw from your invested sum. 

How to Calculate It?

Since you know what is compound interest, now you must learn how to calculate it. The growth with compound interest is significant, which can lead to lucrative returns. 

Formula: A = P (1 + r/n)^nt

• A = the final amount of money you will get at the end of the period
• P = the amount you invested, your principal amount
• r = interest rates
• n = the number of times your interest compounds each year
• t = tenure or the number of years the amount can grow

Also Read: What Is Accrued Interest?

Examples of Compound Interest

This example will give you a better understanding of how to calculate compound interest when it comes to investing. 

Say you invest ₹1,000 in a fixed deposit for 3 years at 10% p.a. Find how much you get with simple interest and compound interest with these terms:

• The principal amount is ₹1,000
• The interest rate is 10% per year
• Compounding frequency is once a year 

Simple Interest	Compound Interest
Interest after year 1: ₹1,000 x 10% = ₹100 Interest after year 2: ₹1,000 x 10% = ₹100 Interest after year 2: ₹1,000 x 10% = ₹100 Total: ₹1,000 + ₹300 = ₹1,300	Interest after year 1: ₹1,000 x 10% = ₹100 New total for year 2: ₹1,100 Interest after year 2: ₹1,100 x 10% = ₹110 New total for year 3: ₹1,210 Interest after year 3: ₹1,210 x 10% = ₹121 Total: ₹1,210 + ₹121 = ₹1,331

In this case, you received ₹31 more thanks to the power of compounding. Imagine what your gains will be when you apply this principle to larger amounts! 

Also Read: Interest Rates On Personal Loans In India

Pros and Cons of Compound Interest

Compounding interest also has its pros and cons. Here are some of the most common aspects of compound interest.

• Builds long-term wealth
• Minimise wealth erosion risks
• Compounding can lead to high interest during loan repayments
• The returns are taxable when it comes to interest earnings in most investments 

Who Gets the Benefit of Compound Interest?

Compound interest helps the investor who receives the interest or gains. Apart from investors, banks and lenders can also earn compounding interest through bonds, loans and investments.

The bottom line is that the long-term outcome of compound interest is very potent for your finances. When it comes to investments like fixed deposits, it can increase your wealth. You can rely on it to achieve long-term goals.

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FAQs on Compound Interest

How is compound interest applied to loans and mortgages?

Based on your compounding frequency, your principal loan amount will increase. The interest rate will be applied to the new accumulated principal. You can easily learn how much it will be if you know how to calculate compound interest or by using a compound interest calculator online. 

Can compound interest help me retire earlier if I start saving now?

It is always wise to start your retirement plan earlier in your life and investing with compounding interest increases your long-term wealth. However, consider taxes to compute your actual returns before you proceed. 

Is the formula for cumulative interest the same as compound interest?

No, the formula for cumulative interest is different from the compound interest formula. 

Cumulative Interest: Principal X Tenure X Rate

Compound Interest: A = P (1 + r/n)^nt

Where:

• A = the final amount of money you will get at the end of the period
• P = the amount you invested, your principal amount
• r = interest rates
• n = the number of times your interest compounds each year
• t = tenure or the number of years the amount can grow

Is compound interest always beneficial to the borrower?

Compound interest is never an excellent option for borrowers as they have to pay more and the principal amount will keep increasing.

How can I avoid missing out on compound interest opportunities?

Discipline is the only answer in this case. If you are investing, try to avoid the temptation to withdraw prematurely to enjoy the power of compounding interest. 

Can compound interest be used for short-term financial goals?

Compound interests can be a great way to achieve your short-term financial goals and build long-term wealth. Using the compound interest calculator formula, you can see how this principle creates a snowball effect on your finances, resulting in overall growth. For short-term goals, you can invest a higher amount.