Did you study the chapter compound interest in school? Do you know about its usage or benefit? If not, then it is never too late. It is time that you should learn the applicability and advantages of compound interest. But why should you learn about compound interest? The answer is pretty simple. If you want to grow your wealth or are already looking for investment ideas, you should invest your money at a compounded rate of interest.
What is Compound Interest?
The concept of compound interest is based on the principle called the power of compounding. In mathematical terms, compounding means interest accrued on interest. When you invest your money in mutual funds, in a project, deposit it in banks as a recurring deposit or a fixed deposit, or in your savings account, you invest a certain amount of capital. What is the point of investing money, though? You get interest on the capital that you have invested. Your money increases depending upon the amount you have invested and the duration.
There are two kinds of interests that are accrued on investments. The first is the simple interest. It applies to the money you deposit in your savings account. The second is the compound interest that you get on recurring deposits, mutual funds, or fixed deposits. In the case of simple interest, the interest is applied only to the amount invested. On the other hand, in compound interest, you not only get interest on your principal amount but also on the interest accrued on that amount.
Let us understand the concept with the help of an example. You have 5,000 rupees in your savings bank account. Simple interest is applied at a rate of 6% per annum. After 5 years, the total interest on your savings will be 600 rupees with the help of formula (PxRxT)/100. The total amount will be 6,500 rupees
Now, when you deposit 5,000 rupees in a fixed deposit for 5 years at 6% compound interest, after the end of 5 years, the interest accrued will be 1691. The total amount received at the end of maturity would be 6691.
When you look at both situations, investment at compound interest gives you more returns in comparison to the investment at simple interest. It is exactly how compound interest helps you grow wealth. The example involved a small amount as a principal. So, the difference between the accrued interest gained in simple and compound interest might not seem too much. However, when you make large investments for a longer period, you will witness a significant increase in your wealth.
Now let us look at the major factors that drive your investment.
The investment amount, also known as the principal, plays a crucial role in the increment of your wealth through compound interest. The entire concept of compound interest is based on your invested capital because the more money you invest, the more interest you gain. In return, you will earn additional interest on the initial interest as well as on the principal. Your money grows in leaps and bounds when compound interest is applied.
Therefore, to put it in simple words, when compound interest is applied to your investment, the more money you deposit, the more you will earn. The more you sow, the more you reap. However, this does not mean that you should invest all your money blindly. Recurring deposits and fixed deposits in banks guarantee money safety. You can invest your money at a compounded rate of interest. However, while investing in mutual funds, you will have to be extra cautious as they do carry risks subject to market fluctuations. In banks, the maximum investment will amount to maximum gain. In mutual funds, the maximum investment might lead to maximum losses also. It is based on risk. Make your investment wisely.
Rate of Interest
The rate of interest is considered to be the most crucial factor while deciding the fate of your investment. It is more important than the principal amount itself. Now let us understand how. Suppose you have 1,00,000 rupees as the principal that you want to invest. Now you have two choices, Bank A offering 9% on long-term deposits and Bank B offering 6% on fixed dep