Do you remember how you used to tackle those problem sums on compound interest and simple interest in school? It’s time to bring back that knowledge because you are going to need it to assess your investments. Particularly, having basic ideas about compound interest will help you better understand why you need it to grow your wealth.
So, let’s jog your memory about compound interest today and show you how it can help your investments. Let’s get started without further ado!
What exactly is compound interest?
Compound interest is the amount of interest earned on a deposit or loan calculated by taking into account both the principal amount and the interest accumulated from the earlier periods. Thus, simply stated, compound interest is the ‘interest earned on interest.’
Let’s explain this factor to you using a simple example. Say you have INR 100 and earned 5% annual interest on that. So, you get INR 105 after a year. If the interest remains constant, then you will get INR 110.25 the year after that. You earned INR 0.25 extra because of the interest on that INR 5.
Now, consider this 0.25 increasing consistently over the years. Then, think of the effect of compounding interest on a bigger sum of money, and you will understand the benefit of it.
In order to calculate compound interest, you will have to multiply the initial amount by one and add the annual interest rate to it. Then, add the number of compounding years or periods and subtract one. The compounding period can be yearly, monthly, or even daily. Sounds like too much math, right? You can use a Compound Interest Calculator available online to get a clearer idea of how it can make your wealth grow.
What makes compound interest so important?
The main reason why compound interest is so important is that it helps your wealth grow consistently and faster. It works way better than simple interest for you because you will not just be getting returns on your invested amount but also on the interest you earn every year on that amount. Thus, you can reach your financial goals by putting away much less money than usual.
If you are trying to build your wealth or accumulate a good corpus for retirement, then compound interest is going to be immensely helpful to you. A tip that you should keep in mind in this regard is to start early because that will give you more time to save up enough money. In fact, if you start right when you begin earning, then you might even save yourself from the common worrying factors like inflation, increasing cost of living, and reduced purchasing power.
The bottom line
Now that you have a clearer understanding of compound interest and its benefits, make sure to consider it as a factor when making investments. You will earn more returns than when simple interest is levied on your money. Remember to talk to your bank or financial institution about this matter.