You may have often heard that certain investments yield returns with a compounding effect. Read on to know more about what compound interest is and who it works.
When managing your finances, you must understand a few important concepts, and compound interest is one of them. Compound interest is a powerful wealth-building tool; it makes the returns on the investments grow more substantially and quicker over time. In other words, it helps you earn higher returns on your savings and investments. It can also be a double-edged sword and work against if you must pay interest on a loan that grows with compounding effect.
What is compound interest?
Compounding means to intensify or the process of growing. Compound interest is the interest you earn on the money that was previously earned as interest. The cycle leads to increasing interest, and the balance in your account increases at a faster rate.
How does compound interest work?
To understand the working of compound interest, you must first know about the simple interest. You deposit a certain amount in the bank account, and the bank pays an interest on the deposit.
For example, assume that you deposit Rs. 100 in the bank account and earn a 5% annual interest, then at the end of the year, your bank account balance will be Rs. 105. What will happen in the following year? This is where compound interest plays a critical role. With compound interest, you will earn interest on the initial principal amount as well as on the interest earned on the deposit
The formula to calculate compound interest
The formula used in the compound interest calculator is
A = P(1+r/n)(nt)
In the above formula,
- A is the future value of the investment
- P is the principal amount that you initially invest
- R is in the compound rate of interest
- N is the number of times the interest is compounded in a financial year
- T is the investment duration
What makes compound interest so powerful?
Compounding happens as the interest continues to accumulate over the period. During the initial first couple of years, the compounding interest may not seem to make a big difference to the fund value, but it starts to grow exponentially in the later years as you receive interest over the interest earned.
The frequency at which the interest is paid matters a lot. A more frequent compounding period will yield better returns. When you open a savings account, you must look for an account that compounds daily.
Compound interest is more effective if you stay invested for a longer period. The more years you allow your money to grow, the faster it will grow.
Another important factor that plays a huge role in your funds’ growth is the interest rate. Generally, with investments that pay simple interest, higher interest rates mean the funds will grow faster. Compound interest can help overcome the high-interest rate, especially if you stay invested for a longer period. An investment with a lower compound interest can grow faster than an investment that offers higher simple interest returns.
The number of deposits and withdrawals you make can have a significant impact on the fund’s growth. If you let your money grow and keep adding new deposits, you will grow your funds faster and get more substantial returns. However, if you withdraw the earnings, it can dampen the compounding effect and reduce your overall fund growth.