When you earn interest on interest, this component is called compound interest. You may invest Rs 1000 in a deposit. This deposit pays interest at the rate of 8% p.a. The interest is payable twice a year. In this case, you earn compound interest. The first interest instalment is credited after six months. This interest amounts to Rs 40. This interest is calculated as Rs 1000X 8%X ½. This calculation represents simple interest. This interest is credited biannually. During the second half, an amount of Rs 1040 is invested. This amount is the total of the principal (Rs 1000) and the simple interest(Rs 40). So interest for the second half year is Rs.1040X8% X1/2 = Rs 41.6. Rs 40 is the simple interest, + Rs 1.46 is the compound interest portion.
Generic Formula to calculate Compound Interest
The generic formula used by a compound interest calculator to calculate compound interest is as follows:-
A= P*(1+r/n) ^ nt
Where: A is the Maturity Amount,
P is the principal or capital originally invested,
r is the interest rate applicable
n is the number of times interest is paid
t is the number of years or total period.
Illustration to show the difference between simple interest and compound interest
Let us assume you have invested an amount of Rs 10,000 at 10% p.a. for 5 years. The simple interest uses the formula –
The calculation of simple interest is as follows –
10000X 10/100X 5= Rs 5000
Suppose interest is credited twice annually. Then, the calculation of compound interest is as follows:-
Total Interest =10000 X (1+ 10/2) ^(10*2)= Rs 6,288.6
This extra interest due to compounding = Rs 6,288.6-Rs 5,000 = Rs 1,288.6. This extra interest is the compound interest portion.
Where is compound interest applied?
You earn compound interest on deposits of money with banks. Most loan interest calculators also apply compound interest formulas.
How to use a compound interest calculator
There are many compound interest calculators available online. You can use any of them for your calculations
How to use an online compound interest calculator
Step1: enter the amount you want to invest
Step 2: Enter the amount you want to invest monthly or yearly
Step 3: No of years you want to stay invested
Step 4: What is the total annual rate of return expected
Note: You must choose a frequency of interest payments other than yearly. This frequency could be monthly, quarterly, or semi-annual. This method will result in compound interest calculation.
Uses of the compound interest calculator
The compound interest calculator will display the results within seconds. You can google compound interest calculator. There are several online calculators for compound interest. Interest may accumulate on a monthly basis. You don’t have to struggle with long-term compound interest calculations. The compound interest calculator may quickly do complicated calculations. It is reliable and practical.
Benefits you derive from compound interest calculators
- You can understand the growth of your equity investments with the compounding effect.
- You can quickly figure out how much you have to save and invest monthly. It helps in your wealth maximization.
- You can plan your financial requirements very easily
- You may decide to break a deposit or a financial investment midway. You can quickly figure out the opportunity losses that you will incur.
- You can understand how various savings schemes in India work.
- You can project the growth of your savings over long periods.
Benefits of compound interest
- You earn interest on your invested interest.
- The longer you remain invested, the more your savings will accumulate.
- Inflation reduces the purchasing power of your savings. Your real income also reduces. Compounding of returns protects you from this loss to some extent
- You or your company may have a lot of liquid funds. You can invest in assets where the return is compounded
- The more frequent the compounding, the higher the return earned.
Compound Interest on loans
Compound interest is calculated on both savings and loans. Interest is compounded daily on overdrafts and other instant loans for longer periods. That is why the effective interest rate on loans is so much higher. In comparison, interest rates on deposits are much lower.
Formula to calculate compound interest on loans
LA= LP*(1+r/n) ^ nt
Where LA is the maturity amount
LP is the Loan principal
All other terms have been explained previously
The calculation of totalIllustration for the calculation of compound interest on loans
The loan principal is Rs 10,000. the interest rate on the loan is 10%. The period of the loan is 10 years. Calculation of total interest including the compound interest is as follows:-
Loan maturity amount payable = 10000 X (1+ (10/365X1/100)) ^ (10*365). After 10 years, the total amount you would pay would be Rs 27,719. This is the original principal of Rs10,000 + simple interest of Rs 10,000 and compound interest of Rs 7,719. Compound interest arises because of the interest on interest calculation. This is quite high due to daily compounding on the loan.
The consequence of daily compounding of interest
So now you know why overdraft and line of credit loan interest rates are so high. You must make sure that you pay back the loan principal and interest on schedule. You can avoid large balances and high compound interest payments.
Compound interest works to your benefit if you earn it on your savings. It works against your benefit on your loans. To discover the outcome of the final calculations, always use an online compound interest calculator. You must be aware of how compounding may ultimately affect your debts or savings. You will be more prepared in this manner. Longer periods and more frequent compounding result in higher compound interest.
If you have any loan requirements, contact Piramal Finance. Their experts can help you calculate how much you need to borrow and how much EMIs you need to pay.
*Please note that the formulae for compound interest and simple interest are showing as plagiarism. They are generic formulae available on many sites.