You might have heard that compound interest is the secret to creating wealth, accelerating growth, and boosting your finances. Well, this article will help you analyze and find out whether it is true or not. To understand the working of compound interest and how it can be beneficial, let us start by understanding what exactly compound interest is.
What is Compound Interest?
Compound interest is getting the same interest on a different principal after each compounding period, usually higher. In simple words, it is a process of earning more in the same period of time compared to simple interest. Before understanding the working of compound interest, let us briefly understand the key components of compound interest.
Key Components of Compound Interest:
- Principal: Suppose an investment of Rs. 500 is made
- Interest Rate: Suppose the rate of interest is 5%
- Time: Suppose the time period is 3 years
- Compounding Frequency: It is the frequency or number of times the amount is compounded in the given duration. For example, on an annual basis, it is done once per year, quarterly it is done four times per year, etc.
How Compound Interest Works?
Compound interest works by adding the interest earned in the previous compounding period to the principal and then using the amount as the new principal for the next compounding period. In this case, the interest earned is not used by the investor but reinvested at the same rate to gain more interest in the next compounding duration.
CI= P×(1+n×100R) n× T− P
Where,
- CI = Compound Interest
- P = Principal amount
- R = Annual interest rate (in %)
- T = Time (in years)
- n = Compounding frequency
(e.g., yearly = 1, half-yearly = 2, quarterly = 4, monthly = 12)
Why Compound Interest?
Benjamin Graham quoted, “The magic of compounding returns is the biggest mathematical discovery of all time.” This shows that compound interest is considered the ultimate tool of wealth creation. Even investing a smaller amount with compound interest consistently can give big returns.
It shows the power of time as it accelerates the growth of the savings. Compounding your savings is basically making a smart move of earning more with minimal effort. The example below will give a clear understanding of why to choose compound interest.
For example:
- In case of compound interest,
P = Rs. 7000, R = 7%, T = 3 years, compounded quarterly
A = Rs. 8,620 - In case of simple interest,
P = Rs. 7000, R = 7%, T = 3 years
A = Rs. 8,470
Therefore, this example shows how the same principal can give a different amount in the same duration of time with a different method of compounding.
Simple Interest vs. Compound Interest
Simple interest is basically taking away the interest at the end of the investment period. It means the interest received on the principal can be used for spending purposes instead of reinvesting it with the previous capital amount.
The table below gives a clear idea about “Simple Interest vs. Compound Interest.”
| Feature | Simple Interest | Compound Interest |
| Definition | Interest is calculated only on the original principal | Interest is calculated on the different principal, i.e., principal + interest earned |
| Formula | SI = (P × R × T) / 100 | CI = P × (1 + R/100) t – P |
| Growth Pattern | Linear growth | Exponential growth |
| Interest Earned On | Principal only | Principal + interest from previous periods |
| Amount | A = P + SI | A = P × (1 + R/100) t |
| Suitable For | Short-term loans or fixed deposits | Long-term investments or savings |
| Example: P=₹1,000 R=10% T=3 yrs | ₹300 (₹100/year) | ₹331 (with annual compounding) |
| Time Effect | Doesn’t change the rate of interest | More time = significantly more returns |
| Compounding Frequency | Not applicable | Can be annual, monthly, daily, etc. |
Bottomline
The conclusion can be drawn that compounding is indeed an effective solution for growing your investments. Now that there is a clear understanding of how compound interest works and why it is important, investors can make a clear decision. Investment is a subjective topic, and the investor must analyze the factors associated with it to make a decision.
Written by – Tanya Kumari