Importance of Compound Interest in an Investor’s Life

When a person invests his money in thestock market orother financial instruments like Forex or government bonds, or even if he is saving his money with the banks, the first thing that strikes the investor is the amount of interest he is going to receive for not consuming the money at thepresent point of time. Most of the investors in India hardly have any proper idea of the power of compounding but they believe they do but who really do understand reap great profits in the long run.

Compound Interest

What is Compound Interest?

Compound interest is the interest amount which is calculated on the original principal as well as it takes into account the accumulated interest of the previous periods. The compounding periods are very important in this scenario as you increase the number of periods, the more amount of interest you will receive.

The investor gets more return on his investment compared to simple interest-bearing financial instruments as simple interest is only calculated on the original period over and over again.

Compound Interest Formula

The compound interest formula used by the investors or traders is same as the one we learned at school; that is;

Compound Interest = [Principal (1+ interest rate) number of periods] – Principal

= [P(1+i)n] – P

= P[(1+i)n – 1]

Example: Suppose you have invested your savings INR 1, 00,000 for 2 years at an interest rate of 10% compounded quarterly.

Then; CI = 1, 00,000 [(1+0.10)8 -1]

= 1, 14,359 (rounded off).

How does it grow over the periods of Investment?

Since compound interest is calculated on both principal and accumulated interest of the previous compounding periods, the frequency of compounding plays the most important role in the growth of the interest. The higher the number of the periods of compounding, the higher the interest you are going to accumulate at the end of the investment. Here is an example;

Let’s assume, aPrincipal amount that is being invested is INR 10000 at an interest rate of 10% p.a. for a period of 10 years. The table below will show how the interest amount will change with the change in the frequency of compounding:

Compounding Frequency No. of Compounding Periods Values for Interest (i) and Number of periods (n) Total Interest Amount (INR)
Annually 1 i =10%, n = 10 15937.42
Semi-Annually 2 i = 5%, n = 20 16532.98
Quarterly 4 i= 2.5%, n = 40 16850.64
Monthly 12 i= 0.833%, n = 120 17070.41

Compound interest is really beneficial to your investment if you are considering investing for a longer period of time. As an investment of INR 100000 under simple interest would reap INR 50,000 after 10 years at an interest rate of 5% while the same principle will reap INR 62,889.46 if you invest it under compound interest for the same number of years.

In compound Interest, the interest amount changes over every period of compounding as the accumulated principal keep on increasing. For example:

Year Opening Balance (P) Interest @ 5% (I) Closing Balance (P+I)
1 INR 10000 INR 500 INR 10500
2 INR 10500 INR 525 INR 11025
3 INR 11025 INR 551.25 INR 11576.25
  Total Interest INR 1576.25  

 

The Power of Compounding

Albert Einstein referred to compound interest as the eighth wonder of the universe and also regarded as the most important invention of mankind. Though compound interest is not good for the people borrowing money it is definitely the weapon for the investors and money lenders. It has thepotential of creating wealth as every penny is accounted for interest calculation. It is also one of the most powerful factors for eroding the losses of investment due to inflation, increasing thecost of living or decrease in the purchasing power.

One of the best financial vehicles to reap the benefits of compound interest is Mutual funds. Mutual funds provide anoptionfor their investor to reinvest the dividend amount in purchasing more units of the fund which in turn increases the potential for wealth creation.

This Post is written by Akriti Vyas a Finance Writer at FinanceWikki which is a best Finance, Investment & BusinessBlog based in India. Over the last few years, she has dedicated to help people from all walks of life to find financial freedom and help them manage their money to relieve daily stress through blogs and videos.

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