If you are an investor, you may have caught the term compound interest. Or you have heard of it when applying for a home or car loan. In either case, someone at the bank would have mentioned it. Each time you borrow or invest money, you will have to pay or be paid interest.
Compound interest is simply the interest earned on the interest that you previously made, which you had reinvested. That is precisely the reason why it's called compound and not simple interest.
How Does Compounding Work?
Let's say you invested ₹1000 [which becomes the principal amount], and you receive 5 percent interest of ₹50 per year. This ₹50 is actually simple interest, which means the interest you have earned based on the principal amount of ₹1000.
Now, in a compound interest scenario, the ₹50 will be reinvested to become part of your investment. Now, there's ₹1050 in your investment. Continuing with the same 5 percent interest rate, you will now earn ₹52.50. So after two years, your total investment would be ₹1102.50.
The formula for compound interest is:
FV = PV × (1+r)^n
where FV = Future Value or the final amount, PV = Present Value or the principal, r = annual interest rate and n = number of periods.
This formula works when you're saving or borrowing money. Since you know the amount to start with [PV], you also need to consider the number of compounding periods [n] and the interest rate [r].
Compound interest is a mechanism that increases the principal amount without adding any more of your money after the initial investment. When it comes to investments, it's regarded as a magic tool to grow wealth. Excellent for savings and investments, but can work horribly against you when paying interest on a loan.
Also Read: Explained: Should You Invest In Tax-Saving ELSS?
What are the factors that influence compound interest?
Compound interest is a combination of the amount you first started with [principal] plus what you earn. When interest is paid repeatedly, compounding takes place. In the first year or a couple of cycles, compound interest may not particularly make an impressive impact. But as interest starts adding over and over again, compound interest begins to show results on your investment.
Five factors make compound interest powerful. They are
- Frequency. The more frequent compounding interests are — daily, for instance — the more dramatic results you can view.
- Time. Long periods are fantastic for compounding interest to show. And that's why you need to leave your money alone to grow.
- Interest rate. A higher interest rate can grow your investment rapidly. But with compound interest, even if it is at a lower rate, it can give you a higher balance amount over a long period.
- Withdrawals. If you withdraw from your investment, you could reduce the effect of compounding. But if you let your money grow while you regularly contribute to the investment that could wonderfully build wealth.
- Principal amount. Regarding compounding interest, a high sum of money to start with may not really make a difference. That's because, whether you are starting with ₹100 or ₹1 crore, compounding interest will work the same way
How Often Is Interest Compounded?
To know how often interest is compounded, you need to look into the compounding period. The span of time when interest was last compounded and when it will be compounded again is known as the compounding period. It helps you experience the power of compounding interest and how to assess it.
For instance, if you have a daily interest account, the compounding period is one day. For semi-annual accounts, it's six months. Similarly, compound interest can be calculated by the following frequencies:
- Daily
- Monthly
- Quarterly
- Half-yearly
- Yearly
The main principle behind compound interest is that the shorter the compounding term, the more interest you could earn. So that means, between annual, monthly and daily compound interest, daily compounding offers the highest interest.
With all things being equal, you stand the chance of better returns on your investments with frequent compounding when it comes to investments. The more regular the compounding, the more it gets credited to your principal balance. That can allow the compound interest to begin earning its own interest quickly. And that's when you realise that the power of compounding lies in the interest earning you interest. Mind boggling indeed!
But when it comes to debt, especially credit cards, compound interest is calculated daily. That means your credit card issuer charges interest to your account every day based on the average daily balance. The more the balance grows, the more interest will add on top of the amount you owe the card issuer.