“Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pay it” – Albert Einstein.
Whenever you make an investment, you expect to earn a return on the same. Typically you earn interest as a return on your investment. When the interest (& principal) are reinvested again, you earn further interest on the same. This phenomenon continues till you withdraw your investment. So, compound interest is the interest earned on the initial principal and the interest of the previous periods. You can efficiently compute it using a compound interest calculator online.
The magic of compound interest ensures that your investment grows exponentially over a long period of time. You can start with small seed capital, water it with regular investments, be patient, and watch it grow into a massive tree over 15-20 years. You may start poor, but you can end up rich with a large corpus at your disposal. A compound interest calculator is a tool that you can use to know what amount you can accumulate at a given rate of return.
How does Compounding Actually Work?
The working of compounding can be understood with the help of a simple example. Suppose you invest Rs.1,000 in a bank FD at an 8% interest rate p.a. Assume that the frequency of compounding is annual, i.e. interest earned on the principal after one year is reinvested again. The situation looks something like this:
Rs.1,000 is invested in a bank FD at 8% (p.a.) for 3 years. At the end of year 1, the investment grows to 1,000 + (8% of 1,000) = Rs.1,080
So at the beginning of 2nd year, the principal is Rs.1,080. At the end of year 2, the investment grows to 1,080 + (8% of 1,080) = Rs.1,166.40
Now at the beginning of 3rd year, the principal is Rs.1,166.40. At the end of year 3, the investment grows to 1,166.40 + (8% of 1,166.40) = Rs.1,259.71
You can observe that the interest earned after every year is reinvested to earn further interest. Rs.1,000 grows to Rs.1,259.71 in 3 years. It is compound interest in action because not just the principal but the interest also earns interest.
Without compounding, the principal of Rs.1,000 would have grown to Rs.1,000 + (80*3) = Rs.1,240. The extra Rs.19.71 is generated due to the effect of compounding. Although the amount looks small here, it can be exponentially large if you invest a bigger sum for a longer period of time.
Calculation of Compound Interest
All the workings shown above can be simplified to a great extent. You don’t have to repeat the steps again, and you can instantly know the final amount with the help of a compound interest calculator formula. The formula is given below.
A = P * [(1 + r/n)] ^ (n*t)
A = Final Amount
P = Initial Principal
‘r’ = Interest Rate (p.a.)
‘n’ = Frequency of Compounding (p.a.)
‘t’ = Investment Tenure (years)
Applying the compound interest formula to the same FD example given above where P = 1,000; r = 8% or 0.08; n = 1; t = 3
A = P *[(1 + r/n)] ^ (n*t)
= 1000 * [(1+ 0.08/1)] ^ (1*3)
= 1,000 * (1.25971)
You can observe that the final amount is the same as earlier. So the formula essentially reduces the effort involved in tedious calculations.
Compound Interest Calculators
The use of a compound interest formula is further simplified with the availability of online tools. All you need to do is to input the variables like the principal, expected returns, time period, etc., to determine the amount you can accumulate at the end of a specified investment horizon.
Note: The accuracy of the output depends upon the inputs. Please ensure that you provide all the values correctly.
Benefits of Using Calculators
- Most online calculators are straightforward and easy to use. You just need to key in the variables.
- Manual calculations are vulnerable to errors. The calculators give you accurate results (if you have entered the inputs correctly)
- A compound calculator is an excellent financial planning tool that can be used to plan & achieve financial goals.
- The calculations can get lengthy & complex if the period is extended and investments are made regularly. Calculators reduce the efforts and provide the results within a few seconds.
Harnessing the Power of Compounding
The primary factors that influence the corpus that you can accumulate are (i) principal amount, (ii) returns, (iii) time of investment and (iv) the number of times the interest gets compounded in a year.
(i) Principal Amount: Bigger the amount that you start the investment with, the more prominent will be the final amount. If you cannot invest a big lump sum, you can make small & regular investments over a long period, like the mutual fund SIP. There are many compound interest calculators in India that can help you plan your SIPs
(ii) Rate of Return: If you choose assets with a high return potential, like stocks & mutual funds, you can accumulate a more considerable corpus
(iii) Time Period: The longer you stay invested, the more prominent will be the final amount you end up with. Choose long-term assets to plan for your long-term goals, like children’s higher education & retirement
(iv) Frequency of Compounding: Compounding may occur on a monthly, quarterly, or annual basis. The greater the frequency, the better it is for your investment.
Understanding how compound interest works is essential for every person who invests and also for people who take loans. You not only earn compound interest on your investments but also pay for it when you borrow money. Once the concept is clearly understood, you can benefit by earning more and paying less.
All your investments and financial planning exercises are no longer cumbersome when you have the compound interest calculator online. You can just key in all the variables and get the results in a jiffy with a few clicks!