Compounding is when you earn interest on your investment over a period of time, due to which you witness a growth on your earnings. Power of compounding enables your earnings to grow as your investments grow. Here's how you can understand this better. An interest is added on the initial investment (principal amount), this interest is the compound interest.Read More Since the amount would be added to the initial investment and the new interest is calculated on this amount, the investment will continue to grow as this process would be consistent all throughout the investment period.Read Less
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Simple interest, as the name implies, is simply the bank interest, expressed as a certain annual percentage, on the principal. In compound interest, the effect is a snowballing one. The interest accumulates on the interest and principal of the previous periods. The simple interest formula is straightforward. Mathematically it can be expressed as principal multiplied by rate and time period.
The formula used here is A= P x R x T (where P stands for principal, R rate of interest and T the time period). In compound interest, the principal keeps on changing every subsequent period. Compound interest is expressed mathematically with the formula A= P (1+R/N) ^ NT. Here P stands for principal, R is the interest rate, N is the number of times interest is compounded in a particular time period and T is the time period.
The number of times interest is compounded in a single period is known as the compounding frequency. The effectiveness of compound interest depends on two factors - the simple interest or nominal interest, and the compounding frequency. The more times interest is compounded on your money, the more wealth you will accumulate.
An investor who starts early can stay invested for a longer time and thus reap the benefits of compound interest. To see why investing early makes a difference to compound interest, try your own calculations here. It is also important to take into account the annual percentage yield when considering compound interest. Annual percentage yield or APY is a figure that tells you what your returns are with compound interest over the period of one year. Annual percentage yield is different from annual percentage rate (APR) which does not take the effect of compounding into account.
Compound interest can be viewed as payment of interest on the interest you have already earned along with the principal, for added measure. The amounts are compounded in each successive period by adding the principal and interest of the previous periods, thus having an exponential effect. This makes the value of your investments grow at a higher rate compared to simple interest where no addition of interest to principal is involved.
To calculate compound interest, you have to multiply the initial amount you invested by one plus the annual interest rate, divided by the number of compounding periods raised to the number of compounding multiplied by the time period the investment is kept.
The formula for calculating this reads as A= P [1+(R/N)] ^ NT. Here A is the final amount after compounding. P is initial amount or principal invested, R the rate of interest, N the number of times compounding takes place in a year and T the time period the money is kept.
Let us work this out with a concrete example. Suppose you want to find out how much Rs 20,000 will be worth after five years if a bank pays you an interest rate of 5 per cent compounded quarterly. Substituting Rs 20, 000 for P, 0.05 for R, 4 for N and 5 for T we end up with a compounded sum of Rs 25, 640.74 at the end of five years. The compound interest rate over five years works out to 28.2 per cent. You can also calculate compound interest rate using Excel spreadsheets or use online calculators such as this one to make the job simpler for you.
Compound interest is a tool whereby the value of ones investment increases. This increase is due to the interest earned on the returns made in one year added to the principal of that same year. The principal of the previous year along with the interest amount of the second year becomes the new principal amount in the second year on which interest is earned.
On the other hand, when you earn simple interest, the money you get is the interest amount depending on the interest rate you were informed of, added to the principal or initial amount you invested. For instance, if you invested Rs 2,000 in a bank which paid you an interest rate of 10 per cent annually, what you would get is Rs 2,200. That is 10 per cent of Rs 2000 plus Rs 2000 (the principal).
In compound interest, the mechanism is complex but works wonders in the long run. For compound interest to be effective, you need to stay invested for a longer period. In compound interest, the interest is paid on the principal plus interest of the previous years and this is done in successive years depending on how long you stay invested.
Under simple interest, you would earn Rs 2200 for every year you invested Rs 2000. However, under compound interest, you would earn Rs 2200 the first year, the second year Rs 2420 (Rs 2200 plus 10 per cent of Rs 2200), the third year Rs 2662 (10 per cent of 2420 added to Rs 2420) and so on.
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