Compound interest is a financial phenomenon that wields the incredible power of exponential growth, transforming small sums of money into substantial fortunes over time. Unlike simple interest, which only calculates interest on the initial principal amount, compound interest continuously accrues interest on both the principal and the accumulated interest. This compounding effect creates a snowball effect, causing the investment to grow at an accelerating rate.
What is compound interest?
Compound interest is the interest calculated not only on the principal amount but also on the interest over time. Unlike simple interest, which is calculated solely on the principal amount, compound interest considers both the principal and interest.
How is compound interest calculated?
To understand how compound interest works, let us break it down into its key components:
- Principal amount (P): The amount of money borrowed or invested.
- Interest rate (r): The rate at which interest is charged.
- Time (t): Tenure for which the interest is calculated, often measured in years.
- Compounding periods (n): The frequency at which the interest is calculated.
Compound interest is calculated using the following formula:
A = P(1 + r/n)^(nt)
Where:
A = the future value of the investment/loan
P = the principal amount
r = the annual interest rate
n = the number of times that interest is compounded per year
t = the number of years
What is the difference between simple interest and compound interest?
Definition:
- Simple interest is calculated only on the principal amount of money borrowed or invested. It does not consider any interest that has already been earned or charged.
- Compound interest considers not only the initial principal amount but also the accumulated interest from previous periods. It involves interest on interest, resulting in a compounding effect over time.
Frequency:
- Simple interest is typically used for short-term loans and investments, and the interest remains constant throughout the entire duration.
- Compound interest is commonly used for long-term investments and loans. The interest is recalculated and added to the principal at regular intervals, such as annually, semi-annually, quarterly, or monthly.
Impact:
- The interest amount remains the same over the loan or investment term, resulting in a linear growth pattern. The total interest earned or paid does not change unless the principal, interest rate, or period is altered.
- The interest amount increases over time due to the compounding effect. As interest is added to the principal in each compounding period, the total interest earned or paid grows exponentially. Compound interest allows for significant growth in investments and may lead to a higher total repayment amount for loans.
Formula:
- The formula for calculating simple interest is straightforward:
Interest amount(I) = P (principal) x r (interest rate) x t (time in years) - The formula for calculating compound interest is more complex:
A = P(1 + r/n)^(nt)
Compound interest is widely used in various financial instruments, such as savings accounts, certificates of deposit (CDs), bonds, loans, and investments. Borrowers may end up paying more interest on a loan than they initially borrowed due to the compounding effect.
If you are looking to calculate your loan EMI amount, we suggest using a personal loan EMI calculator instead of doing it manually. You simply have to enter the loan amount, period, and interest rate.
