Check how much you can earn with Power of Compounding
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Invested | Interest | Maturity amount |
---|---|---|
₹5 Lacs | ₹7.97 Lacs | ₹12.97 Lacs |
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Compound Interest was called the 8th Wonder of the World by Albert Einstien. It is what makes your money grow so that even small amounts can over time create a huge corpus. ET Money’s compound interest calculator is a free, online tool that you can use to find out how your small savings will accumulate over time to make you wealthy.
Invested | Interest | Maturity amount |
---|---|---|
₹5 Lacs | ₹7.97 Lacs | ₹12.97 Lacs |
Compound interest is simply the interest earned on interest. You earn compound interest when you earn interest on not only the original principal amount invested as well as the interest that accumulates on such principal. For example, say you invested ₹100 in a bond or fixed deposit that pays 5% interest per annum. At the end of 1 year, the amount due to you will be ₹105. However, when the interest is calculated the next year, it will be calculated on ₹105 and not ₹100. Hence, you shall earn interest on both ₹100 (principal) and ₹5 (the interest earned), taking the value of your investment to ₹110.25. And so on, for every consecutive year till you remain invested. This is called compound interest. When the amount invested is large and the time period is longer, the calculation for interest can become a little complicated, and that is where a compound interest calculator is useful.
A compound interest calculator makes it easier to calculate compound interest so that you don’t need to make any manual calculations. You can also use a compound interest calculator to calculate returns on investments that offer compounding returns, like mutual funds. Suppose you’re trying to analyse your investment’s maturity value. In this case, you will just need to enter the invested amount, rate of return, and period, and the calculator will tell you the maturity value. If you’re about to invest in an asset that pays compound interest or which generates compounding returns (like a mutual fund, for example), you could use a compound interest calculator online to see what your returns would look like or how much interest or returns will be earned over a certain time.
An online compound interest calculator uses the compound interest formula to calculate the total interest. The formula has three variables:
Here, N represents the total number of times that compounding occurs over a given time period. For instance, if you’ve made an investment for 10 years and the compounding frequency is half-yearly, N will be 20 (i.e., 10 years x 2 times/year).
The N is important because the compounding frequency may differ from one investment to another. An online compound interest calculator will give you the option to choose from a monthly, quarterly, yearly, etc. compounding frequency so you can choose the frequency appropriate for your case. When you input the required number in the compound interest calculator, the algorithm will do the math for you and display the total interest you’ll earn over the investment’s holding period.
The compound interest formula is simple and involves three variables. The P in the compound interest formula stands for the principal amount of the investment, and R stands for the interest rate. The N in the formula stands for the total number of times the interest is compounded. Therefore, the compound interest formula is:
Where:
P = Principal amount
R = Rate of interest
n = Compounding frequency per year
N = Total compounding frequency for the entire period calculated as (n x T); n being the compounding frequency per annum and T being the time period in a number of years.
Now that you know the compound interest formula let’s use it to calculate compound interest. Say you’ve invested ₹5,00,000 in a Fixed Deposit that compounds interest quarterly. The Fixed Deposit offers a 5% p.a. rate of return, and you keep the amount invested for 5 years.
Let’s identify the values of the variables we need and then plug those values into the compound interest formula.
Therefore, total compound interest earned:
As time passes, the effects of compounding start to become more pronounced. The returns or interest generated over prior periods get added to the principal increasing the principal amount, and therefore the interest thereafter is earned on a higher principal.
As the value of the exponent (n x T) in the formula increases, the interest compounds with greater speed. The compounding frequency (n) remains unchanged; what changes is the time (T) and consequently the total compounding frequency (N).
As a rule of thumb, the more time you allow the principal to grow, the bigger will be your accumulation on which you’ll earn interest. For instance, look at the previous example. We divided 5% by 4 because the interest compounds 4 times each year, effectively compounding 20 times in 5 years. Though the actual investment period is 5 years and the rate is 5%, the formula takes the time as 20 and the rate as 1.25% (5% ÷ 4).
This effectively increases your yearly interest rate. Say you receive compound interest at 1.25% per quarter on ₹100 instead of 5% per annum. At the end of the year, you’ll have ₹105.0945 (instead of ₹105 had you earned 5% per annum). The impact, of course, is much more pronounced on larger figures and longer investment horizons, where the power of compounding becomes more apparent.
For instance, say you’ve invested ₹1 lakh in a fixed deposit that generates 10% per annum, and compounds quarterly. Since the interest compounds quarterly, the effective interest rate is slightly higher at 10.381%.
Here’s what the effective rate generated will look like over the years, when we compare annual compounding to quarterly compounding-
Period | Value of Investment (compounded yearly) (effective interest rate = 10%) | Value of Investment (compounded quarterly) (effective interest rate = 10.381%) |
---|---|---|
1 year |
₹1,10,000 |
₹1,10,380 |
5 years |
₹1,61,051 |
₹1,63,852 |
10 years |
₹2,59,374 |
₹2,68,499 |
The power of compounding has been said to be phenomenal by the likes of Warren Buffet. What’s important though, is to realise that the power of compounding works in your favour when you earn compound interest, but not when you’re the one paying it. To that point, you can leverage the power of compounding by investing in a range of assets, including mutual funds, fixed deposits, or even PPF.
For instance, consider an equity mutual fund investment worth ₹1,00,000 per annum. Assuming it returns 10% p.a., your investment will grow to the following amounts over different periods:
Period | Total Invested Amount | Value of Investment |
---|---|---|
1 year |
₹1,00,000 |
₹1,10,000 |
5 years |
₹5,00,000 |
₹6,71,561 |
10 years |
₹10,00,000 |
₹17,53,116 |
15 years |
₹15,00,000 |
₹34,94,973 |
20 years |
₹20,00,000 |
₹63,00,250 |
Over 20 years, your value of investment will more than triple vis a vis the invested amount — and that’s the power of compounding.
ET Money’s compound interest calculator is fairly easy to use. You need to enter three inputs to get your total interest amount — the principal invested, the rate of interest earned, and the holding period of the investment.
Once you’ve entered all three variables in the calculator, it will automatically calculate the total gains and total corpus that you’ll accumulate by the end of the tenure. If you have a target corpus that you’re aiming for, you can tweak the rate of interest or the principal to see its impact on the maturity value.
The conceptual difference between simple interest and compound interest lies in the amount on which the interest is earned. However, there are several other differences between them.
Differentiating Point | Simple Interest | Compound Interest |
---|---|---|
Amount on which interest is earned |
Simple interest is earned only on the invested amount (principal) |
Compound interest is earned on the invested amount (principal) as well as the interest earned on it |
More Returns Under Which Method |
The total interest earned is lower with simple interest as compared with compound interest. |
The total interest earned is relatively higher with compound interest and therefore favourable for investors. |
Computation |
Simple interest formula: |
Compound interest formula: |
The formula discussed in the previous sections can be inserted into an Excel cell to calculate compound interest:
You can also use the built-in Excel function called the Future Value function to calculate compound interest. Future Value is a financial term representing the amount your principal will grow into over a specific time period.
It’s difficult to calculate compound interest manually since the compound interest formula is a little complex. You can use an online compound interest calculator to calculate compound interest or use an Excel sheet, input the data, and apply the formula to a cell.
All banks offer compound interest on almost all accounts, including a savings account. Banks also offer compound interest on other products such as fixed deposits, recurring deposits, etc.
The power of compounding comes from the fact that the investor’s mutual fund returns in each period are automatically added to the principal. The returns for the next period are earned on the principal plus the mutual fund returns earned during the previous period. Your annual returns, therefore, keep increasing each period. What’s more, the investment may also offer a higher compounding frequency. For instance, an investment that offers daily compounding interest earns more than an investment that offers quarterly compounding interest.