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    What is Compound Interest?

    Jul 28, 2024
    5 min
    4 Rating

    Compound interest is a method for growing your savings quickly. It means that in addition to earning interest on the principal amount, you also earn interest on previous periods. Yes, you heard that right! You will earn interest on your already compounded earned interest! Compound interest wields exponential growth power, transforming small amounts of money into considerable ones. It calculates the principal amount that constantly accumulates interest on the principal and the accumulated interest. It creates a snowball impact, helping the investment expand at an escalating rate.

    Compounding interest is among the most indomitable forces when planning finances. By letting you make the most of your returns, compound interest assists you in achieving your aims more quickly. Therefore, what is compound interest, and why does it impact investment portfolios? How does it work, and what is the formula? You will get answers to the questions as you scroll down and read through the article!

    Compound Interest Meaning

    Compound interest refers to the process where interest is computed on the principal amount and the accrued interest of previous tenures. As time advances, the amount of earned interest hikes, escalating investment growth and debt. Compound Interest is often used in savings accounts, investments, and loans. The compounding frequency, like yearly, quarterly, or daily, impacts the accumulated interest. Compound interest can result in considerable savings growth or substantial increases in debt if not managed properly.

    Formula of Compound Interest

    Compound interest can be perplexing for a first-time reader. Do not worry. To simplify it for you, below is the mathematical formula and an example:-

    The formula of compound interest is:

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

    Where,

    A indicates the final amount you will receive

    P depicts the initial principal amount

    r is the interest rate

    N means the number of times the interest is applied, and

    t implies the time passed (in years)

    Now, let’s understand the concept with a simple example. Suppose Sonali opened a bank account with a financial establishment with a 4% compound interest monthly. Let’s speculate that Sonali will not withdraw or deposit any money from her bank account for convenience.

    Sonali's account is credited with Rs.12,000 on the existing balance of Rs.30,000 and her new balance becomes Rs.42,000

    If Sonali earned Rs.1,248 interest in the following month, it would likely be calculated based on the new balance of Rs.42,000, not the original principal amount of Rs.30,000.

    If Sonali’s account had offered simple interest, she would have earned only Rs.1200 monthly. Moreover, in the third month, she earned a Rs.1297 compound interest amount, and this is how it would continue.

    The calculations provided above are based on assumed rate of interest and it are meant for illustration purposes only.

    Advantages and Disadvantages of Compound Interest

    Now that you know the compound interest meaning, let’s understand its pros and cons. Below are the merits and demerits of compound interest:-

    Pros of Compound Interest

    The following are the pros of compound interest:-

    • Escalated Growth: Compound interest lets investments grow swiftly because of the compounding effect.

    • Passive Income: It creates a source of passive income because the earned interest is reinvested, resulting in possible wealth accumulation.

    • Long-Term Privileges: It multiplies the initial investment of long-term investors substantially.

    • Financial Aims: Compound interest helps people meet their financial objectives by maximising the returns, such as retirement savings or education funding.

    Cons of Compound Interest

    Here are the cons of compound interest:-

    • Debt Accretion: Compound interest can result in substantial debt burdens if not managed adequately.

    • Losses: Compounding can augment losses in case of market downturns in investments.

    • Time Dependency: Compound interest needs time to work efficiently. Therefore, late beginnings can restrict its benefits.

    • Inflation Risk: Inflation can corrode the value of compounded returns as time passes, especially for low interest rates.

    Strategies to Make the Most of Compound Interest

    Explained below are some strategies to maximise the power of compound interest:

    • Opt for the Appropriate Investment Option

      Begin by selecting the right investment instrument. Fixed and recurring deposits are famous in India for their steadiness and assured returns. Compare interest rates from banks and other financial establishments to familiarise yourself with the most competitive rates. Also, factors like the tenure and compounding frequency several establishments offer should be considered.

    • Choose a Monthly Interest Payout

      Several financial establishments in the country offer the monthly interest payout option. This can be beneficial if you need a monthly income stream. If you opt for this option, you can receive a part of your earned interest while letting the remaining interest compound. It balances using funds for your daily expenses and making the most of your savings growth potential.

    • Reinvest the Investment

      Consider reinvesting the interest you earn from your savings. Instead of withdrawing your earned interest, you can reinvest it into the same investment option or explore other opportunities. This constant reinvestment lets your investment compound at an escalated pace and contributes to the growth of your wealth.

    • Diversify Your Investments

      Even though FDs and RDs offer steady returns, diversifying your investment is significant. Explore investment options like mutual funds, stocks, real estate, etc., offering high returns but with high risk. In addition to making the most of your returns, diversification alleviates risks linked to one investment option.

    • Opt for Long-Term Investments

      Compound interest is perfect for long tenures. Suppose you are planning for retirement or funding education. Consider investing in long-term avenues with high interest rates. Long tenures will enable more compounding terms, making the most of your savings growth. Nevertheless, ensure a steady financial plan to evaluate your liquidity requirements before pledging towards long-term investment avenues.

    Final Thoughts

    So that is all about compound interest meaning. It is widely used in various financial tools like savings accounts, deposit certificates, bonds, loans, and investments. You might pay more interest on a loan if you borrowed the amount earlier because of the compounding impact. The long-term impact of compound interest on savings and investment is more powerful as it expands your money more quickly than simple interest and has become a major factor in growing wealth. It also alleviates the increasing cost of living caused by inflation. Compound Interest offers youngsters an opportunity to benefit from money’s time value. While selecting your investment, remember that the number of compounding tenures is as important as the interest rate.

    Note: The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable

    Mutual Fund investments are subject to market risks, read all scheme related documents carefully.