Whether you take a loan or invest money, there are two basic types of interest: simple interest and compound interest. Simple interest is a specific percentage of the principal every year, and most loans are not given out on simple interest. However, most investment options like fixed deposits and most recurring deposits pay returns based on simple interest.
What is Compound Interest?
Compound interest, on the other hand, is applied to both loans and deposit accounts. Compound interest essentially means "interest on the interest" and tends to multiply money faster and give more returns on your investment, whether you are a bank or an investor. Compound interest is the reason many investors are so successful - be it institutional investors or individuals ones like you.
How to Compare the Benefits of Compound Interest vs Simple Interest?
Quite simple really. To help you understand this easily, we’ll try to give you a couple of examples of how simple and compound interests are calculated.
Let’s say you invest Rs.10,000 at a simple interest rate of 8% per annum. At the end of the first year, Rs.800 is added to your account. At the end of the second year, another Rs. 800 in interest is added, and so on for the third year, the fourth year, etc.
On the other hand, if your investment paid compound interest at a rate of 8% per annum, it wouldn't make a difference at the end of the first year, since you would receive the same Rs. 800 as interest payment for your investment, just like you would with simple interest. However, this is where the calculation starts to change.
In the second year, the 8% interest is calculated not just on your investment of Rs. 10,000 but on the entire new balance of Rs.10,800. This results in an interest payment of Rs.864 for the second year, a net profit of Rs.64 in comparison to simple interest. This is then added to the principal when calculating your interest for the third year. In other words, the principal amount for the third year becomes Rs. 11,664.
You will be surprised to see how quickly this can add up. At 8% simple interest, your Rs.10,000 investment would be worth Rs. 34,000 after 30 years. However, using compound interest, the value would shoot up to more than Rs.100,000 for the same time duration. Adjusting this against different and periodic investment amounts, you can watch your money grow much faster, without the associated risks of investing in stocks, bonds, or mutual funds.
Sounds great? But that’s not at all. The frequency at which compound interest is calculated can also make a huge difference.
In the earlier example, what we saw was annual compounding -- which means that the interest is calculated once per year. In reality, compound interest is often calculated more frequently. Typical compounding intervals are quarterly, monthly, and daily, but different institutions and models use different frequencies.
The frequency at which compound interest is calculated makes a lot of difference -- specifically, more frequently the compound interest, the more your returns are likely to be. For example, an investment of Rs. 10,000 which provides a return of Rs. 800 at an annual compounding frequency as we have already seen, will give you returns of Rs. 824 at a quarterly compounding frequency, and Rs. 830 at a monthly compounding frequency. Over a period of 10 years, your investment of Rs. 10,000 will become Rs. 21,589 at annual compounding frequency, while it will become Rs. 22,196 at a monthly compounding frequency. These numbers may look small in the example, but over a 10 year period, you’re likely to invest a large amount of money, and the difference in profit could run into lakhs!
There are many online compound interest calculator that automatically calculates your investment maturity amount, depending on the amount invested, rate of interest provided by the financial institution and the tenure of investment. Click here to check the Compound interest calculator from Upwardly.
With this knowledge, you can compare and be selective about the best investment plans by looking at the details of whether they provide you returns at simple interest or compound interest, and maximise your returns by investing in the savings plans which give you the best possible rate at the best frequency. What’s more, if you ever need to take a loan, you can also choose the right loan option based on who is charging the least interest.
