What is Compound Interest? Formula, How It's Calculated

Written by : Knowledge Centre Team

2022-09-19

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People have been investing in various financial instruments and finding several ways to build their wealth. One of the easiest ways to grow your money is to invest it in options which offer compounding returns.

What is Compound Interest?

Compounding interest is the interest where accrued interest on invested capital is regularly reinvested. Thus, after some time your previous interest also starts to earn interest, and this is what is called compounding. In other words, your capital continues to grow with time. So, the longer you stay invested the higher interest you can earn.

Here’s an example, you invest Rs 1000 with a compound interest of 5%. After a certain period, the money you earn will be 5% of Rs 1,000 which is Rs 50, and the balance of Rs 1050. Now instead of earning Rs 50 more the next time, you earn Rs 52.50. As you get some interest on previously earned Rs 50. Bigger investments create more profit in longer terms.

How does Compounding Work?

Compounding is when your previously earned interest starts to earn more interest. Basically, by stacking up the interests, you earn extra money. If you invest money in a compounding return option like Fixed Deposits, your capital will earn interest every quarter.

For example, if you make an FD of Rs 50,000 for 4 Years with a quarterly compounding interest rate of 5% p.a. Means the accrued interest will be reinvested four times a year. After three months you earn 1.25% of Rs 50,000 which is Rs 625.

Duration	Invested Amount	Interest Accrued
0	50,000	625
Q1	50,625	632.81
Q2	51,258	640.72
Q3	51,899	648.73
648.73	52,547

After the first three months, you will earn an interest of Rs 625. For the next quarter, this 625 is ploughed back into your capital and the next interest is Rs 632.8.

If you invested only for a year, at the end of the year your total FD value will be Rs 52,547 instead of Rs 52,500 as it would be at a simple rate of return. If you stay invested for 5 years in this FD, your total value will be Rs 64,102. Compare this with Rs 62,500 you would earn at the simple rate of return of 5% p.a.

The gap between the simple rate of return and compounding return increases with time. In other words, the longer you stay in the compounding investment, the higher your rate of growth is. This phenomenon is known as the ‘power of compounding’.

How to Calculate Compounding Interest?

You need to know more than just how compound interest works. You need to know the formula to calculate your earnings from your investment. The formula to calculate compound interest is –

FV = P(1+r/n)^(n*t)

In which,
P = Principal Amount
r = Annual Interest Rate
n = Number of times a year when interest rate compounds
t = Total amount of time
FV = Future value after ‘t’ amount of time

Compounding and EMI

Finance is a great factor in our lives. Now and then we buy stuff and when we can’t afford it, we take loans. Loans are great ways to buy things when you don’t have enough money temporarily. However, this borrowed money shouldn't be taken lightly.

EMIs are compounding interest in reverse. When you don’t pay your EMIs on time, the interesting part of your EMIs also earns interest. Thus, causing a cascading effect and increasing your interest the more you delay the payment.

If you aren’t punctual about the payment of EMIs then you might end up repaying an extra amount than negotiated. So, make sure to pay your EMIs within the due date.

Investment Options with Compounding Returns

The majority of the long-term investments in India offer compounding returns. Few of the most prominent of these investments are as follows:

1. Mutual Funds

Mutual funds have been a popular investment choice due to their flexibility in accepting investments. You can start with small amounts, even an amount as small as Rs 500. You can invest in a mix of fixed-income securities and equity stocks through mutual funds.

The growth is compounded quarterly in most mutual funds with long-term investment objectives. Mutual funds like ELSS also allow tax deductions on invested money.

Mutual fund returns are linked to the market. Thus, you should invest in mutual funds as per your risk appetite.

2. Fixed Deposits

One of the best features of FD is that it acts as savings and earnings at the same time. You can invest in an FD for a certain amount of time and don’t have to worry about it. In other markets, rates and fluctuations disturb your earnings. FDs are Fixed and definite for the investment tenure you choose.

3. Public Provident Fund (PPF)

Public Provident Fund is one of the best investment options to grow your money beyond inflation and taxes. The long-term nature of the investment makes it great for compounding your wealth. Here are the salient features of this investment:

Only Indian Residents can invest in the scheme
The minimum investment term is 15 years
You can extend the account in batches of 5 years multiple times
A partial withdrawal facility allows you to earn a tax-free pension after retirement (if you have built a corpus in the fund)
The minimum investment is Rs 6000 a year or Rs 500 p.m.
Accrued interest, partial withdrawals and maturity values are exempt from tax
Interest is compounded annually (at the end of the financial year)
However, it’s much more than just a tax-saving method, rather you can earn from it. The interest is calculated from the lowest balance in your account every month. So, make sure to keep your expenses at a minimum while investing in PPF. Further research should also be done as many aspects affect every investment.

4. National Pension Scheme (NPS)

After retirement, NPS can be of great help. National Pension Scheme gives equal growth opportunities to both employed and self-employed workforce in India. Salient features of NPS are as follows:

Start investing as early as 18 years of age and continue up to 70
Normal withdrawals are allowed only after 60. So, it brings the needed discipline for retirement safety
The minimum investment is Rs 500 p.m.
Money is invested in a diversified portfolio to provide long-term growth

5. Life Insurance Savings Plans

Savings plans from life insurance companies like iSelect Guaranteed Future from Canara HSBC Life Insurance offer long-term, guaranteed compounded growth much like PPF. However, with a significant difference:

Enhance your life cover as you build wealth
Guaranteed bonuses for long-term investors
Premium protection option for the policyholder to protect maturity value of the plan
Easy loan facility for emergency financial situations

6. Unit Linked Insurance Plan (ULIPs)

ULIPs are some of the most versatile life insurance plans with significant wealth-building potential. The tax-saving quality of the investment makes it one of the best portfolio investments available, along with the following features:

Invest in diversified portfolios of equity and debt funds
Free bonus units for long-term investors
Lock-in period of five years, after which partial withdrawals are available
Save and draw tax-free pension with plans like Invest 4G ULIP from Canara HSBC Life Insurance:

Start investing in a plan for up to 99 years of age
Invest up to the age of 60-65
Start drawing on the accumulated funds using a partial withdrawal facility
Use systematic withdrawal to automate your tax-free pension from the plan

Life cover ensures your family has a minimum guaranteed life cover

World-renowned scientist Einstein himself has called compounding the 8th wonder of the world. Compounding returns are the mainstay of wealth creation.

Compound interest is a great tool for investors and the easiest way to financial freedom. Market-linked investments which offer compounding can greatly enhance your wealth over time. You should ensure adequate long-term investments if you want to benefit from the power of compounding.

Disclaimer: This article is issued in the general public interest and meant for general information purposes only. Readers are advised to exercise their caution and not to rely on the contents of the article as conclusive in nature. Readers should research further or consult an expert in this regard.

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