From the Pythagoras theorem to the complicated trigonometry formulae, Maths was always scary. Amidst all this, compound interest was just another formula. You learnt it, placed values in the formula and got the answer. The need to understand its application was never felt. But now, as grown-ups, compound interest can help you build your wealth.
Suresh and Arjun are twin brothers. At 25, Suresh started investing Rs.10,000 every year at 8% rate of interest. Arjun, however, began investing at 35. He invested Rs.20,000 every year at 8% for the next 30 years. At 65, who had more money – Suresh or Arjun?
You think Arjun earned more wealth than Suresh. Wrong! At the age of 65, Suresh had Rs.23,97,810 and Arjun had only Rs.18,46,917.
How? Let us have a look.
What is compound interest?
It is the interest on interest. In case of compound interest, the interest is calculated on principal amount as well as the interest accumulated so far. So, logically, every time you calculate compound interest, the base amount increases.
How is it calculated?
Compound interest = P [(1 + r)n – 1]
Where, P = Principal amount, r = rate of interest, n = number of compounding periods
The final amount at the end of the tenure= P(1 + r)n
Say, you took a fixed deposit of Rs.30,000 for a period of 5 years at an interest rate of 9%. The amount of interest payable would be:
Rs.30,000 [(1 + 0.09)5 – 1] = Rs.30,000 [1.538 – 1] = Rs.16,158
Decoding the ‘interest on interest’ concept
Unlike simple interest, compound interest takes into account the interest earned in previous period. Thus, the principal amount for subsequent term increases. Thus, the value grows. Here’s how.
Rs.16,158 in the above example is earned over a period of 5 years. The interest earned every year will vary as explained below:
If you compound the interest more number of times, the interest earned will be higher. Thus, every year, if you are compounding the interest monthly, quarterly or bi-annually, the value of r and n in the formula will change.
Bi-annual compounding will change the interest rate in above example to 4.5% and compounding period to 10. Quarterly will make the interest rate 2.25% and period as 36.
An increase in compounding period can substantially increase the total interest earned.
Experts and financial planners always suggest starting to invest early in life. Compound interest is the reason. The sooner you begin investing, more will be the compounding period more will be the returns earned. Shed your childhood fear of match and become friends with compound interest. It will help you plan your finances better.