There are two types of interests, i.e. simple interest and compound interest. While the simple interest is paid only on the principal amount, under the compound interest, the interest paid in the previous month is added to the principal amount to give you a new balance in your account. The interest for the following month is payable on this new balance. Below is all the information about compound interest.
Whether you put any money away in a bank or borrow money from a financial institution, an interest is applicable. With savings you earn interest and with borrowings, you are liable to pay interest.
Whether it is saving or borrowing, you can also expect one of the two types of interests – simple interest or compound interest. With simple interest, you pay the interest only on the principal amount. However, with compound interest, the interest that you pay in the previous month is added to the principal amount to give you a new balance in your account. The interest for the following month is payable on this new balance.
In simpler terms, compound interest means that you get ‘interest on interest’.
Compound interest is extremely beneficial when you are looking at a savings account. It is a great way to earn more with your savings. Unlike simple interest, which only takes into account the initial deposit, compound interest gives you the advantage of a new account balance each month with added interest. This amount may not seem very high initially. However, with long-term deposits, you can earn quite well on your savings with compound interest.
The flip side of compound interest lies in making any repayments. Now, with any loan such as a Home Loan, Car Loan, or Personal Loan, the repayment is broken down into monthly installments. So, you won’t really have to worry about compound interest. However, when it comes to Credit Cards, compound interest can get you in trouble. If you only pay off the minimum amount on the balance due, you will be charged a compound interest on the remaining amount. This can make the repayment amount extremely high within a short period of time.
The basic difference between simple interest and compound interest lies in the amount that the interest is charged on. To help you understand better, here is a detailed difference between simple interest and compound interest:
|Simple Interest||Compound Interest|
|This interest is only levied on the principal amount or the loan amount.||The interest is levied on the loan amount as well as the interest that is added to it each month.|
|This is a small percentage of the principal amount as agreed between the lender and the borrower.||This is a percentage of the principal amount along with the simple interest that is earned upon the principal amount as agreed upon by the lender and borrower.|
|Wealth and repayment amount in case of loans increase steadily.||Whether it is savings or the repayment on your loan, the growth of the amount is faster because of compounding.|
|The returns with simple interest are lower.||You get higher returns with compound interest.|
|The principal amount does not change.||Interest is added to the principal, making it increase accordingly.|
|Simple interest is very easy to calculate as the formula is straightforward.||This is harder to calculate because of the compounding on the principal amount.|
You have the advantage of several online EMI calculators to help you calculate compound interest on savings and borrowings. However, it is important for you to know how this value is determined to manage your wealth better.
Now, compound interest may be calculated either monthly or annually.
Calculating compound interest annually
The formula used for compound interest per month is:
Principal x (1+rate of interest) tenure
Calculating compound interest monthly
The formula for the compound interest calculated monthly is as follows:
Principal x (1+rate of interest / 12) tenure
To help you calculate your compound interest easily, you have the option of using an online compound interest calculator. In order to calculate your compound interest, all you have to do is enter the rate of interest offered on your savings account or levied on your loan, the tenure of your loan or the time that you wish to put away savings for and the principal amount.
These compound interest calculators also allow you to calculate the principal amount, rate of interest and the tenure of investment or loan in advance. That way, you know how much you need to invest to get a sizeable return or the tenure that you need to invest it for. You are also able to calculate the expected repayment amount so that you can plan your finances accordingly.
Understanding compound interest is quite simple. Once you know a few facts about compound interest, you will be able to use it well to your advantage to increase your savings and to also manage your repayments towards your loans and other borrowings better.
Here are some facts about a compound interest that you should know if you are thinking of making any important financial decisions in the future:
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