Simple interest and compound interest – these are the two methods of calculating interest charged on the loans taken, a deposit made in a bank, etc. Well, no matter whether you borrow funds from a bank or Non-Banking Financial Company(NBFC), the interest charge is always attached. So, the borrower needs to know simple and compound interest to make a sound decision. In this blog, we will be discussing the concept of compound interest, compound interest calculator, how it works, and the difference between compound interest and simple interest.
Compound interest is the calculation of interest where the interest amount is added along with the principal amount. This means, all the previous interest paid or earned will be taken into consideration while calculating next time. The Compound interest calculator helps in checking the final amount you will be getting after the completion of the tenure of the plan.
How Compound Interest Works
Simple interest is a set percentage paid on the initial principal. If you borrowed Rs.1,000 and agreed to pay it back three years later at 20% annual interest, you would owe Rs.600 interest plus the Rs.1,000 principal you borrowed.
If you had an Rs.1,000 loan with interest that compounded 20% annually, you would owe 20% on the annual balance, which would increase every year. After three years, you would owe Rs.1,728 — Rs.1,000 in principal and Rs.728 in interest because every year the previous year’s interest is added to the principal.
Most loans don’t compound annually but instead use a daily, weekly or monthly increment. If it is a debt, the amount you owe also will increase more rapidly. More frequent compounding means your money will grow more quickly if it is in a bank account with compound interest charged on it.
Advantage of Compound Interest
- Save Early and Often: When growing your savings, time is your friend. It takes a while to get momentum. The momentum will build and eventually gain strength. Be patient, leave your money alone, and think long term.
- Check the APY(Annual Percentage Yield): To compare bank products such as savings accounts, look at the APY. It takes compounding into account and provides a true annual rate. It’s easy to find because banks typically publicize the APY since it’s higher than the interest rate.
- Keep Borrowing Rates Low: In addition to affecting your monthly payment, the interest rates on your loans determine how quickly your debt grows, and the time it takes to pay it off. It’s difficult to pay off double-digit rates.
The disadvantage of Compound Interest
The disadvantage is that if the interest charged on credit cards is compounded then it could be a burden on the card holder. The interest charged to outstanding balances can be very high. Also, unless you read the small print you aren’t going to be prepared for the way interest is charged on your card. For example, if you move a balance across from one card to another that transfer will be at a very low rate. But if you go out and purchase something else with that same card the new purchase will be at a very high rate and the burden of interest won’t ever shift off you until you pay all the bills of the credit card.
How to calculate
Compound interest is calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods raise by no of compound periods multiply no of years.
The formula for calculating compound interest is:
= A = P (1 + r/n) ^ nt
(Where P is the principal amount, r is the rate of interest per annum, n denotes the number of times in a year the interest gets compounded, and t denotes the number of years.)
Examples-
An amount of Rs.1,500 is deposited in a bank paying an annual interest rate of 4.3%, compounded quarterly. What is the balance after 6 years?
Using the compound interest formula, we have that
P(Principal) = 1500,
r(rate of interest) = 4.3/100 = 0.043,
n(no of times in a year the interest is being compounded) = 4,
t(no of years) = 6.
