In other terms, it can be said that compound interest is the exponential growth of money without making any additional deposits. For example, A deposits Rs. 100 in a bank and the bank pays 5% annual interest on the deposit. At the end of the first year, A would gain Rs. 5 and now he has Rs. 105 in his account. This means that A’s deposit has already gained interest and now over the next year, A will earn 5% interest on the new account balance, i.e., Rs. 105. This is how the Magic of Compounding works and the deposit keeps gaining interest over the years.
Let us take an example where you wish to invest Rs. 10,000 in a 30-year investment product with a 5% annual compounded interest rate. At maturity, you would have Rs. 43,219, i.e. Rs. 10,000 plus Rs. 33,219 in interest. On the other hand, if only simple interest would be earned on this investment, the amount would stand at Rs. 25,000, i.e. Rs. 10,000 plus Rs. 15,000.
Thus, it is understood that as the principal, interest rate and compound periods keep on increasing, so does the future value of one’s investment.
Calculation of Compound Interest
Compound Interest can be calculated with the help of a compound interest calculator. However, it can be calculated manually by multiplying the annual interest rate by the principal starting value. Next, the result is added to the principal starting value and that is the new principal value.
Compound Interest leads to exponential growth for the investors as their original amount grows faster. Even minor investments can yield major returns with compound interest and this can cause a “snowball effect”, which means that it can build wealth over a while into a large snowball.
Another major advantage of compound interest is that it is associated with the time value of money, which means that the value of money changes, depending upon, when it is received. Compounding Interest allows money to grow over a while. For instance, if someone has Rs. 1000 today, it is best to invest it right away because it can help generate dividends and interest income. However, if someone waits a year to receive that Rs. 1000, they lose out on the chance to earn compound interest for that year, which is known as Opportunity Cost.
It can be said that opportunity cost is an opportunity lost, i.e., there is a loss of possible gains if an action is not chosen at the right time. In the aforesaid case, opportunity cost is equal to the amount of money one does not get in interest, if they do not invest that amount.
The key to compounding is to reinvest the interest payments and accordingly, this becomes the basis for calculating future interest payments. In other words, a snowball effect is created whereby one is earning interest upon the principal plus all interest that one has earned previously. Thus, it magnifies the investments and results can be seen in the longer run when wealth is created.
Compound interest forms the base for an important principal in finance called “time value of money”. The compound interest formula is used to calculate the difference between the future value and present value of an asset. This principal is used in every calculation of finance and investing and hence, the importance of compound interest cannot be denied.
In conclusion, compound interest is one of the most powerful forces for generating wealth over a certain period. The long-term effect of compound interest is magical and acts as a central factor for increasing wealth.