Basics

Basics of Finance
What is compound interest ?How does it impact return on investments?

Compound interest is an essential component of investment, which is calculated on the sum of principal and accrued interest.

When you deposit money in a bank, you earn interest on the principal amount. If the annual interest is calculated only on the principal amount every year, it is known as simple interest. However, if the interest is calculated on the total amount i.e. the principal amount as well as the interest earned in the past, it is known as compound interest.

If interest is calculated on the total amount i.e. the principal as well as the interest earned in the past, it is known as compound interest.

The calculation

Calculating compound interest on a given amount is a simple procedure that involves factoring in the increased principal amount that includes the interest accumulated over the years. The most commonly used formula is:

A = P (1+r/n)nt

P = Initial investment
r = Rate of interest
n = Number of times the interest is compounded in a year
t = Number of years
A = Amount after adding compound interest

This formula can be explained with the help of a simple example. Say you invest Rs 10,000 for a period of 5 years at an interest rate of 8 percent per annum. Under simple interest, the interest amount after 5 years would be Rs 4000, whereas the interest for the same period compounded annually would be Rs 4693.28.

ROI and compound interest

As shown in the example above, investments with a compound rate of interest earn better return on investment (ROI) than ones with simple interest. For investments in which the interest rate is compounded twice a year or more, the return on investment(ROI) increases at an even faster rate. Hence, if given a choice, it would be more profitable if you select a compound rate of interest while making investments.

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