The proper knowledge and prudent management of personal finances play an important role in wealth appreciation and financial analysis. Besides giving you a sense of independence, it also helps you plan your finances according to your financial goals.
A key aspect in this regard is the rate of interest. Whether one is paying it on the availed credit or receiving it on the money invested, it is important for one to know not only how much is it but also how it is calculated and how it compounds.
The power of compounding is considered highly important for wealth appreciation. So, what is compound interest or what is the meaning of compound interest? What is the formula of compound interest? How does compound interest work? Let’s find out the answers to all these questions and many more!
What is compound interest Rate?
So, let’s begin by answering the most basic question in this regard – what is compound interest? or what is the compound interest definition?
Well, compound interest refers to a cumulative interest amount calculated on the principal deposit/loan amount and the interest earned/payable on it during its tenure. It is a very powerful formula in the sense that it calculates interest even on the accrued interest. This way, it makes the principal amount grow exponentially!
The effect of compounding depends on two factors namely the rate of interest and the frequency of compounding. The higher the interest rate and the higher the frequency, the larger would be the effect of compounding. Interest rates can compound at any frequency such as yearly, half-yearly, quarterly, monthly, weekly, bi-weekly, or even daily!
It is beneficial for investors to invest in financial securities or instruments that offer compound interest as this allows them to earn interest even on the interest earned by them in the preceding period.
However, for borrowers, it is not beneficial to pay compound interest. As this can lead them into a never-ending spiral of debt!
What should be the annual rate of compound interest?
Another interesting question that one must ask is what should be the annual rate of compound interest. Well, there is no correct answer to this question! The higher the interest rate the better it is when one is the investor. However, the lower the compound interest, the better it is when one borrows funds and needs to pay interest on them.
How to calculate compound interest?
After knowing what is compound interest, it’s time to understand what is the formula of compound interest.
what is the formula for calculating compound interest?
Compound interest can be calculated using the below-mentioned formula –
Compound Interest = P(1+r/n)^nt – P
P = Principal amount
r = Rate of interest in percentage terms
n = Number of times the interest is compounded in a year
t = Tenure of deposit/loan
Let’s understand how compound interest works with the help of an example –
Mr. A deposits Rs. 50,000, which bears a compound interest of 10% per annum and a tenure of 5 years. So, what is n in compound interest for Mr. A, it is 5.
Compound interest earned by Mr A after 5 years = 50,000 (1+0.1/1)^(5*1) – 50,000
= Rs. 30,525.5
However, if his deposit attracted a simple interest of 10% per annum for 5 years, then he would have just earned an interest of Rs. 25,000.
Simple interest earned by Mr. A after 5 years = Principal Amount * Interest Rate * Time Period =50,000*0.10*5
How to use a compound interest calculator?
After knowing what is the formula of compound interest, let’s learn what is a compound interest calculator and how it works.
A compound interest calculator is an online tool that lets you calculate the compound interest on your investment instantly and in an error-free manner. One can use the Tata Capital Compound Interest Rate Calculator using the below-mentioned steps for making a sound financial decision –
Step 1:Type-in your investment amount. Make sure you have entered the lump sum amount at this stage.
Step 2: Selected your expected rate of interest from the given range of 1%-30%. You can easily find this interest rate online for the investment option that you are considering.
Step 3: The final step requires you to select your investment tenure. We provide a range of 1-30 years, choose the number that matches your investment horizon.
That’s all. You are done! Once you complete the above-mentioned steps, the future value of your investment will be displayed on the left along with the estimated value for your investment gains.
How to Make the Most of compound interest?
One can make the most of the compound interest with their investment in two ways. One way to leverage the compound interest rate effect is to opt for a longer tenure. With more time, the interest gets compounded more frequently and thus helps one have a larger investment corpus.
The second way to make the most of the compounding effect is by keeping increasing the invested amount at a defined interval. Or, one can choose not to make withdrawals from the investment to keep the invested amount large and so does the effect of compounding.
It is good to know varying personal finance terms inside out for robust financial planning. But, it is always better to seek expert advice for your finances. For more information on what is compound interest or how compound interest works, feel free to reach out to experts at Tata Capital or simply visit the website to know more!
Q1. What is the meaning of compound interest?
Compound interest simply means an interest rate that takes into account the effect of compounding. That is it pays interest even on the previous compounded interest along with the principal.
Q2. What is the formula of compound interest?
If you are wondering what is the formula of compound interest, then here it is –
Compound Interest = P(1+r/n)^nt – P
Q3. What should be the annual rate of compound interest?
It’s quite often for people to ask what should be the annual rate of compound interest. However, there is no defined answer to this question. Still, for investment purposes, a compound interest rate would lie in the range of 7%-10%. However, the higher it is, the greater the effect of compounding.
Q4. How does compound interest work?
So, how does compound interest work? The simplest way to understand how compound interest works is by thinking of it as an interest rate that is also applicable to the previous interest earned by you towards an investment.
Q5. What is n in compound interest?
One of the most common questions people have is what is n in compound interest? Well, n refers to the number of years for which the investment has been made or the loan has been availed. One earns the compound interest rate during the entire period defined by ‘n’.