Whether you put any money away in a bank or borrow money from a financial institution, an interest is applicable. With savings you earn interest and with borrowings, you are liable to pay interest.
Whether it is saving or borrowing, you can also expect one of the two types of interests - simple interest or compound interest. With simple interest, you pay the interest only on the principal amount. However, with compound interest, the interest that you pay in the previous month is added to the principal amount to give you a new balance in your account. The interest for the following month is payable on this new balance.
In simpler terms, compound interest means that you get 'interest on interest'.
Compound interest is extremely beneficial when you are looking at a savings account. It is a great way to earn more with your savings. Unlike simple interest, which only takes into account the initial deposit, compound interest gives you the advantage of a new account balance each month with added interest. This amount may not seem very high initially. However with long term deposits, you can earn quite well on your savings with compound interest.
The flipside of compound interest lies with making any repayments. Now, with any loan such as a Home Loan, Car Loan or Personal Loan, the repayment is broken down into monthly instalments. So, you won't really have to worry about compound interest. However, when it comes to Credit Cards, compound interest can get you on trouble. If you only pay off the minimum amount on balance due, you will be charged a compound interest on the remaining amount. This can make the repayment amount extremely high within a short period of time.
The basic difference between simple interest and compound interest lies in the amount that the interest is charged on. To help you understand better, here is a detailed difference between simple interest and compound interest:
|Simple Interest||Compound Interest|
|This interest is only levied on the principal amount or the loan amount.||The interest is levied on the loan amount as well as the interest that is added to it each month.|
|This is a small percentage of the principal amount as agreed between the lender and the borrower.||This is a percentage of the principal amount along with the simple interest that is earned upon the principal amount as agreed upon by the lender and borrower.|
|Wealth and repayment amount in case of loans increase steadily.||Whether it is savings or the repayment on your loan, the growth of the amount is faster because of compounding.|
|The returns with simple interest are lower.||You get higher returns with compound interest.|
|The principal amount does not change.||Interest is added to the principal, making it increase accordingly.|
|Simple interest is very easy to calculate as the formula is straightforward.||This is harder to calculate because of the compounding on the principal amount.|
You have the advantage of several online EMI calculators to help you calculate compound interest on savings and borrowings. However it is important for you to know how this value is determined to manage your wealth better.
Now, compound interest may be calculated either monthly or annually.
Calculating compound interest annually
The formula used for compound interest per month is:
Principal x (1+rate of interest) tenure
Calculating compound interest monthly
The formula for the compound interest calculated monthly is as follows:
Principal x (1+rate of interest / 12) tenure
To help you calculate your compound interest easily, you have the option of using an online compound interest calculator. In order to calculate your compound interest, all you have to do is enter the rate of interest offered on your savings account or levied on your loan, the tenure of your loan or the time that you wish to put away savings for and the principal amount.
These compound interest calculators also allow you to calculate the principal amount, rate of interest and the tenure of investment or loan in advance. That way, you know how much you need to invest to get a sizeable return or the tenure that you need to invest it for. You are also able to calculate the expected repayment amount so that you can plan your finances accordingly.
Understanding compound interest is quite simple. Once you know a few facts about compound interest, you will be able to use it well to your advantage to increase your savings and to also manage your repayments towards your loans and other borrowings better.
Here are some facts about compound interest that you should know if you are thinking of making any important financial decisions in the future:
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In order to know how much you have saved based on compound interest, you need to know the current balance in your account. To calculate the amount that you will have to repay towards a borrowing, the principal amount or the loan amount should be known. All further calculations are based upon the amount that you start off with.
In case of loans and borrowings, the interest rate is applicable throughout the tenure of the loan. When it comes to savings accounts, you have the option of choosing a high interest rate account for a short period of time or can just place your money in a savings account for as long as you please. The interest is paid for the tenure that you keep the account active for. The longer you keep your account, the higher are the returns that you will get on it.
In case of loans or other borrowings, the interest rate varies as per several factors. This includes the type of loan that you are choosing, your eligibility criteria, the bank that you choose, and so on. Even with savings accounts, the interest rate changes as per the bank that you choose and the type of account that you opt for. If you are choosing a loan or a savings plan during any offer period, make sure that you understand how long this is valid for before you agree to the terms and conditions.
The interest on the loan amount is calculated on a monthly basis to allow EMIs repayment options. If you have an outstanding balance on your Credit Card, the interest is calculated on a daily basis and is payable at the end of each month. Now, when it comes to compound interest on savings accounts, the interest is calculated daily and is paid at the end of every month or annually. Of course, it is a good idea to choose monthly repayments as you have a higher principal amount each month that is compounded.
This question is with respect to compound interest upon your savings accounts. You can choose to put away any additional funds that you get in the form of a bonus or a gift into your savings each time. You can also choose to put away a part of your earnings aside into your savings account each month. The latter is a wiser choice as you have a higher principal amount or balance to work with for improved returns.
With an online compound interest calculator, you can check the monthly repayments that you may have to make on your borrowings. It also allows you to calculate the tenure for which you will have to invest to get the lowest repayments and highest benefits. Lastly, if you are confused about the interest rate, you can calculate this quite accurately too. All you have to do is fill in necessary details and the calculator provides you with accurate results.
As discussed above, compound interest does have its benefits and its flipsides. One way to work around the negative effects of compound interest towards loans is to pay a little more than your minimum balance every month. This works best with larger loans such as your home loan or a car loan. But, when it comes to the smaller debts like your credit card bill, the best option for you is to make sure that you pay off the whole amount in one go to avoid compounding and higher repayments. However, if this is not possible, you can use the same concept as the larger loans and increase repayments steadily each month.