People have been lending and borrowing money since earlier times. This give and take policy has been possible only because it has proved mutually beneficial for both the parties. Individuals and business houses take out loans to purchase assets, pay off loans, medical expenses, student loans, trade and for business expansion.
Some things in life are worth the effort of taking out a loan and going into debt. If you are securing your financial future then the debt or loan is a sensible investment but make sure that the terms are discussed and interest rates are decided before the deal is signed.
Nowadays there are two ways to calculate interest on the principal, simple and compound interest but the most common and popular one is, of course, compound interest. Remember it is important to know beforehand that you will be able to pay off your loan within the agreed time-frame hence calculate the probable interest rate beforehand and then work accordingly to lead a peaceful existence.
What is compound interest?
As we all know there are two ways to calculate the interest on the loan amount and compound interest is one of them. It is in vogue as most money lenders prefer this mode to arrive at the actual repayment amount of loan.
When an individual takes out a loan, the interest has to be calculated for the first period that has been agreed upon. It can be daily, weekly, fortnightly, monthly, quarterly, bi-annually and annually. The interest is then added with the principal amount and now the interest is calculated on the accrued amount. The principal on which you should calculate your interest is not the principal that you started with but the amount that you have arrived at after adding the interest for the first period. This becomes a recurring theme as the interest is added repeatedly after the setup term period.
Hence when the interest is added with the actual investment amount for the next phase of calculation it is known as compound interest because now for the upcoming period the interest is calculated on this new amount which is the principal amount plus the accumulated interest. When someone opts for the compound interest he has to pay interest on the interest and this is why the amount is higher if compared to the amount derived after applying simple interest. The power of compounding gives it an edge over simple interest as the lender can generate more income via this method.
Benefits of compound interest
Earnings can grow exceptionally well because of the compound interest. As time passes the interest on the actual investment enhances and the principal amount keeps on changing for the good. If you are an investor always opt for compound interest as it will prove a potent factor in creating wealth.
Compound interest equation
Determining the interest via compound interest method sounds complicated but actually, it is not so. The process has been simplified because of the equation that can easily help you in arriving at the result. The compound interest formula is
Compound Interest = P (1+ r/n )(nt) – P
If you need to calculate the amount payable then the formula is
A = P (1 + r/n)(nt)
In this formula
- A = accrued amount or amount payable
- P = principal amount
- I = interest amount
- R = annual nominal interest rate in percentage
- r = annual nominal interest rate as a decimal
- r = R/100
- t = time involved in years for instance 0.5 years is 6 months
- n = number of compounding periods per unit t, at the end of each period.
How to calculate compound interest?
A lender loves the thought of levying compound interest on the principal whereas a borrower hates the idea of having to repay the loan via compound interest that keeps on accumulating through-out the debt period. Can you actually calculate the compound interest properly or do you have half the knowledge that helps to get an estimated sum so that you can arrive at a probable number?
Once you understand the basics it will be easy for you to do your calculations. You are now aware of the formula of compound interest and you just need to play around with actual figures and voila you will be ready to tackle and calculate the compound interest on the principal easily and effectively. In order to explain the concept of compound interest in simple terms let me give you a demonstration.
Suppose Sourav took out a loan of 10000 for 3 years at 6% interest that will be compounded annually then how will you arrive at the payable amount?
The first year the interest is 6% of 10000 = 600
For the next year the actual principal becomes 10000 + 600 = 10600 and 6% interest is = 636
For the third year, the principal becomes 10600 + 636 = 11236 and the interest on this amount is = 674.16 and the total amount payable after three years is 11910.16.
This is when the number of compounding period is one year and if it is quarterly, monthly or bi-annually obviously the interest will shoot up.
How to calculate compound interest with the help of the formula?
Suppose Ravi took out a loan of 10000 for 4 years at 5% rate of interest and you need to calculate the compound interest and the amount payable at the end of the term. If in the above scenario the compounding period is every year then the compound interest will be
Compound Interest = P ( 1+ r/n )(nt) – P
Compound Interest = 10000 ( 1 + 1.05/1 ) 1*4 – 10000
Compound Interest = 10000( 1.05 )4 -10000
Compound Interest = 10000 * 1.21550625 – 10000
Compound Interest = 12155.06 – 10000
Compound Interest = 2155.06
The compound interest after four years is 2155.06 and the amount payable is 12155.06. The first thing you should know is the number of compounding period as it will make a significant difference while calculating the interest. Suppose instead of 1 year the compounding period was every month then the interest will shoot up considerably as it is compounded at a greater pace.
How to take advantage of compound interest
- If you are a borrower then make sure that you are making the compounding factor work in your favour. For example when you are making loan repayments make sure you are making half of your payment twice every month instead of the full amount once a month. It will help to cut down paying off period and save a good amount of money which you would have spent as interest. Thus as a person increases the frequency of his loan repayments he will be able to boost his net worth.
- Keep your borrowing rates low and pay the debts quickly and with extra money so that you can take down the amount of debt quickly.
- If you are an investor then compound interest can prove highly rewarding. The longer you allow the interest to compound the greater is its actual growth. The funds that can take advantage of compound interest are stocks with reinvested dividends, savings account, and IRAs. Retirement investments are the main beneficiaries of this scheme as the compound interest helps it in reaching the desired amount successfully.
- Start investing early in life so that your savings can grow at a good pace. It is the head start that will prove a blessing in building and maintaining a momentum that will gain strength as time passes by. Even if that person stops saving after a point in time he would have already built a good nest egg that would keep on growing and accumulating over the years via compound interest.
Money is not available for free to borrow as you will have to pay a fee as interest for the opportunity of using it. The lending institutions and banks have been in existence since earlier times as borrowing and lending money has been a part of our life. The borrowing culture has resulted in huge profits for the money lenders as they calculate the repayment via compound interest.
Lending money has turned out to be a lucrative business as people are repaying the loan with interest on interest. Remember compound interest is a double-edged sword. Beware if you are a borrower and make merry if you are an investor.