If you are someone who is planning to borrow money or take loans, you must know about Compound Interest. Read the article to know what compound interest is and how it works.
When money is borrowed or lent, a certain amount is charged as interest. This interest depends upon the amount, the time period for which the money was borrowed, as well as the rate of interest. The interest that is charged can be of two types: simple interest and compound interest.
It is the one that is usually used in bank loans and credit cards. This type of interest does not only depend upon the principle, time period, and rate of interest but also on the accumulated interest that the borrower has already paid. In this article, we will read about compound interest, its importance, and its calculation.
Compound Interest
When you deposit some money and the interest you get on it depends on the principal amount and accumulated interest from previous months.
There are numerous additional alternative intervals that can be used in addition to the frequently used quarterly, monthly, and daily compounding periods.
If you need help calculating the interest you can take help from the online compound interest calculator provided by Vakilsearch. This online calculator will save you time and calculate the interest you have to pay on the borrowed money.
Simple Interest vs. Compound Interest
Compound interest operates differently than simple interest. Only the principal is used to compute simple interest. When computing simple interest, earned interest is not compounded or invested back into the principle.
If you were to calculate your annual income using simple interest, you would receive ₹50 if your account balance was ₹1,000 and earned 5% annual interest. The accrued interest would not be deducted from the original principle. You’d receive an extra ₹50 in year two.
On auto loans and other types of shorter-term consumer loans, simple interest is usually employed to compute the interest charged. Credit card debt accrues interest over time, which is why it seems as though it might grow so fast and significantly.
In a perfect world, compound interest can be used to compute your savings and investments while simple interest can only be used to calculate your debts.
Importance of Compound Interest
It is an important term when it comes to financial management.
- As compound interest is used in banks the amount to deposit in your savings account benefits from it. If you start investing money at a younger age in the savings account it is more beneficial as the compound interest will keep on increasing which will give you more benefits in the long run.
- Compound interest is also used by banks when you take loans. The interest that you pay on the loan taken is compound interest. In this case, if it is not working in your favor as you have to pay interest on the amount you took as a loan as well as the interest that you have already paid.
- When you use a credit card and the amount is due on it banks take a certain amount of interest. This interest is compound interest. Therefore if you do not pair credit card news soon the interest will keep on increasing depending on the time period the dues are left unpaid.
Calculation of Compound Interest
To Calculate the amount you can use the following formula,
A= P(1 + r/n)nt
Where,
A = the final amount;
P = the principal
r= the rate of interest (in decimal)
n= the compounding frequency;
t = time period in years.
- The starting balance used to calculate interest is referred to as the “principal.” The phrase can also refer to your first investment amount, albeit it is more frequently used to refer to a loan’s starting balance. For instance, if you choose to invest ₹10,000 for a period of five years, that sum will serve as your principal for computing compound interest.
- Rate is the decimal representation of the interest rate (or anticipated rate of return on investment). For purposes of calculation, you would enter 0.07 if you anticipated a 7% annual growth rate for your investments. The frequency at which interest is compounded on the principal is referred to as compounding frequency.
- Using the 7% interest rate as an example, you would simply add 7% to the principal once a year if annual compounding were used. On the other hand, semi-annual compounding entails applying half of that sum (3.5%) twice a year. Quarterly (four times a year), monthly, weekly, and daily are some additional popular compounding frequencies.
- Additionally, there is a mathematical idea known as continuous compounding, where interest is continuously collected.
- Time is a fairly self-explanatory notion, but remember to describe the entire amount of time in years in order to calculate compound interest. In other words, use 2.5 years in the formula if you plan to invest for 30 months.
Vakilsearch can make this calculation process easier for you. It has an online Compound interest calculator in which you can enter the principal amount, the time period for which it was borrowed, and the rate of interest at which it was borrowed. The calculator will use this information and give you the compound interest on it.
Conclusion
One of the most important benefits that is it grows at a faster rate than simple interest. Simple interest gives fixed amounts of money as the interest on the principal amount whereas compound interest is based on the principal amount as well as the accumulated interest of each month. Because of the faster rate of growth of compound interest, it is usually used for bank credit card and loan purposes.
If you want help in calculating interest, You can go to the website of Vakilsearch. It has an online compound interest calculator that helps you in calculating the Compound Interest you have to pay on the amount you borrowed. Go to the website of Vakilsearch and enter the basic information about the money you borrowed such as the principal amount, interest rate, and time period. Once you enter these details, the calculator will give you the interest to be paid on it.
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