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Did you study the chapter compound interest in school? Do you know about its usage or benefit? If not, then it is never too late. It is time that you should learn the applicability and advantages of compound interest. But why should you learn about compound interest? The answer is pretty simple. If you want to grow your wealth or are already looking for investment ideas, you should invest your money at a compounded rate of interest.
What is Compound Interest?
The concept of compound interest is based on the principle called the power of compounding. In mathematical terms, compounding means interest accrued on interest. When you invest your money in mutual funds, in a project, deposit it in banks as a recurring deposit or a fixed deposit, or in your savings account, you invest a certain amount of capital. What is the point of investing money, though? You get interest on the capital that you have invested. Your money increases depending upon the amount you have invested and the duration.
There are two kinds of interests that are accrued on investments. The first is the simple interest. It applies to the money you deposit in your savings account. The second is the compound interest that you get on recurring deposits, mutual funds, or fixed deposits. In the case of simple interest, the interest is applied only to the amount invested. On the other hand, in compound interest, you not only get interest on your principal amount but also on the interest accrued on that amount.
Let us understand the concept with the help of an example. You have 5,000 rupees in your savings bank account. Simple interest is applied at a rate of 6% per annum. After 5 years, the total interest on your savings will be 600 rupees with the help of formula (PxRxT)/100. The total amount will be 6,500 rupees
Now, when you deposit 5,000 rupees in a fixed deposit for 5 years at 6% compound interest, after the end of 5 years, the interest accrued will be 1691. The total amount received at the end of maturity would be 6691.
When you look at both situations, investment at compound interest gives you more returns in comparison to the investment at simple interest. It is exactly how compound interest helps you grow wealth. The example involved a small amount as a principal. So, the difference between the accrued interest gained in simple and compound interest might not seem too much. However, when you make large investments for a longer period, you will witness a significant increase in your wealth.
Now let us look at the major factors that drive your investment.
Investment Amount
The investment amount, also known as the principal, plays a crucial role in the increment of your wealth through compound interest. The entire concept of compound interest is based on your invested capital because the more money you invest, the more interest you gain. In return, you will earn additional interest on the initial interest as well as on the principal. Your money grows in leaps and bounds when compound interest is applied.
Therefore, to put it in simple words, when compound interest is applied to your investment, the more money you deposit, the more you will earn. The more you sow, the more you reap. However, this does not mean that you should invest all your money blindly. Recurring deposits and fixed deposits in banks guarantee money safety. You can invest your money at a compounded rate of interest. However, while investing in mutual funds, you will have to be extra cautious as they do carry risks subject to market fluctuations. In banks, the maximum investment will amount to maximum gain. In mutual funds, the maximum investment might lead to maximum losses also. It is based on risk. Make your investment wisely.
Rate of Interest
The rate of interest is considered to be the most crucial factor while deciding the fate of your investment. It is more important than the principal amount itself. Now let us understand how. Suppose you have 1,00,000 rupees as the principal that you want to invest. Now you have two choices, Bank A offering 9% on long-term deposits and Bank B offering 6% on fixed deposits. You plan to invest the same for 10 years. If you choose to go for Bank A, the total amount that you will receive at maturity (10 years) will be 2,36,736 rupees. You will receive an accrued interest of more than the principal itself—1,36,736 rupees.
The same amount, if invested in Bank B, would fetch a final amount of 1,79,085. It means an accrued interest of 79,085 rupees. Now, as you can see, everything being constant, the same amount of principal when invested at two different rates of interest gives you a significant difference in the amount (57,652 rupees) received at the end of maturity. What seemed like a small differential of 3% resulted in a difference of a huge difference of 57,652 rupees, almost 58% more returns of your principal amount. So that’s the power rate of interest holds in compounding.
Period of Investment
Another very important factor in compounding is the period for which you will be investing. In the example above, if the same amount invested in Bank A would have been deposited for 15 years instead of 10, the amount you would have received at maturity is 3,64,248 rupees. The compounding works even quicker after a certain period. The difference in the interest accrued between 5 years (57,652 rupees), 10 years (1,36,736 rupees), and 15 years (2,64,248 rupees) would give you an idea. Hence, the longer your period of investment, the more you would gain from the transaction.
How can Compound Interest Help You?
- If you have a limited or fixed source of income- Compound interest helps a great deal in increasing wealth for people who have a limited or fixed source of income. If you get a fixed salary each month, it is advisable to cut down on your expenses and invest your savings in a recurring deposit bank account. Not only will your principal amount be saved, but your money will increase over time as well. Investing your money at compound interest is the best way to increase your wealth. You can deposit a fixed sum of money each month as a recurring deposit in the bank. The interest keeps on accumulating over the years.
- Increased income in less time- In comparison to simple interest, compound interest is beneficial if you want to gain more income in less time. Since you get an additional interest on both the principal and the amount of interest, your income increases rapidly. Therefore, if you want to gain more in a short amount of time, you should go for a compounded rate of interest rather than simple interest.
- Money keeps growing if you invest it for long periods- If you invest your money at a simple interest rate, it takes years to get it doubled. However, if you invest it at a compounded rate of interest, the money gets doubled sooner. The majority of the people invest their money as fixed deposits in banks for 5 years, 10 years, or even more than that. The interest on your principal for all these years gets accumulated and turns into a huge sum of money. The additional interest on the interest also keeps on growing for years. At the time of maturity, you get almost double the amount of money than your principal amount.
You can invest for a short period too, such as for 2 or 3 years, but it will give you less interest, and your money will not increase with as much speed as it does during a long period of investment. The longer your period of investment is, the more your wealth will increase.
If you want lump-sum money- If you have one bank account, it gets difficult to manage your savings and expenses. To buy an expensive thing such as gold or a car, a lot of people pay the money in installments. Some money as a downpayment is still required. But, how can you make savings if you keep on spending the money? Therefore, it is advisable to invest a fixed amount of money, such as 5,000 rupees, as a recurring deposit in a bank account for some years. At the time of maturity, you will get lump-sum money that you can use to make a down payment or make another investment. People also deposit a large amount of money in banks as fixed deposits. You again compound interest for years on the fixed deposit sum.
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