The extraordinary power of compound interest

Compound Interest

Written by Aryan Agarwal

April 21, 2020

Have you heard about ‘Interest’ in financial terms? If you haven’t, don’t worry, we will learn about it here. Interest is the cost of using somebody else’s money. When you borrow money, you pay Interest; When you lend money, you earn interest. When it comes to calculating interest, you can figure it using two ways—simple and compound interest.

Simple interest means that you get a fixed percentage on the principal every year and thus is rarely used. On the other hand, compound interest is applied to your loans, investments, saving accounts, DEBT, and all the other financial things that accumulate interest. Compound interest means that you earn your interest in your interest, and that has made investors extremely rich.

Albert Einstein famously said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” And I agree. Compound interest at first seems like a simple concept that most people ignore, although when looked closely, it can provide you with one of the best or the worst things in your life.

Albert Einstein, eighth wonder of the world, compound interest

Simple interest can be calculated by a simple interest formula learned in school. You can figure it by multiplying the principal amount with interest rate and time. Simple interest can be represented as S.I. you can check this calculator for simple interest.

Simple Interest Formula

How to calculate Compound interest?

Compound interest is calculated using a specialized formula that can be daunting to remember. Here, you will find this formula and you can check this calculator.

Compound Interest Formula

Why is compound interest so much better than simple interest?

Let’s say that you invest ₹ 10,000 at 7% simple interest F.D for ten-year. That means you get ₹ 700 each year. That’s not bad considering you receive ₹ 7000 at the end of your ten-year period.

Although, if you had invested that ₹ 10,000 at 7% compound interest F.D for ten years, you would have received ₹700 for the first year, just like simple interest, but for the second year, you would have received ₹749. For the third year, you would have received ₹801, which is then tacked on to the principal when calculating your interest for the third year. At the end of your ten-year period, you would have received ₹9,671 as interest. That’s a difference of ₹2,671, and the gap only increases with time.

You would be surprised to see how quickly compound interest adds up. Your ₹10,000 grows to ₹57,000 in thirty years. When you invest your money, in the long term, it grows like this. This is called exponential growth, and this can make you an extremely wealthy individual. The biggest drawback of compound interest is that when you take on ‘DEBT,’ this compound interest works against you to rise exponentially to increase your debt with time.

Chart showing difference between compound and simple interest

Compound interest causes a snowball effect shown in this graph as your original investment and your earned interest earns money for you.

Therefore, to be wealthy, you must not be in DEBT; if you are, your first step should be to pay your DEBT. If you do not have any DEBT, then you should start investing as soon as possible, as that will make money work for you using compound interest.

the importance of time when investing

Rule of 72

Rule of 72 is a beneficial and straightforward method to calculate the power of compound interest. You can use this to get a basic estimate on when the principle amount will get doubled given the interest rate is fixed. You take the interest rate and divide that by 72.

 For example, I took the interest rate as 7%, so dividing it by 72 will be 72/7= 10.28 or roughly ten years. You can check and verify this on the compound interest calculator for yourself.

Using the rule of 72 will help people learn and understand how compound interest can quickly accelerate your earnings.

Rule of 72

How can investors receive compounding returns?

Letting your money work for you by investing your money in your prefered assets for the long term. If you can keep investing for the long term consistently and with a well thought out strategy, then you can grow your wealth over time.

The key to compound interest has always been time and always be time.

The more time you give your investment, the faster it will grow.

Frequently Asked Questions(FAQs)

What is compound interest?

Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.

Explain compound interest with an example

If you had invested that ₹ 10,000 at 7% compound interest F.D for ten years, you would have received ₹700 for the first year, just like simple interest, but for the second year, you would have received ₹749. For the third year, you would have received ₹801, which is then tacked on to the principal when calculating your interest for the third year. At the end of your ten-year period, you would have received ₹9,671 as interest.

Compound interest formula

Simple interest formula

What is the Rule of 72

Rule of 72 is a beneficial and straightforward method to calculate the power of compound interest. You can use this to get a basic estimate on when the principle amount will get doubled given the interest rate is fixed. You take the interest rate and divide that by 72

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1 Comment

  1. Monika

    Good going… explained in easy way

    Reply

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