Pros and Cons of Compound Interest

Pros and Cons of Compound Interest

Compound interest, also known as compounding, is one of the easiest ways to create wealth over the long-term. And it is super easy to calculate as well. All that you need to do is use a compound interest calculator. 

However, the concept of compound interest has both advantages and disadvantages. In this article, we’re going to take a look at just that. But then, before we go ahead with it, let’s quickly take a look at this simple concept and how it works. 

What is compound interest? 

When you deposit a certain sum with a financial institution such as a bank, you generally earn interest on it. And if you choose to reinvest this interest that you earned along with the principal sum, what would happen? 

You would essentially get to earn interest on both the principal sum as well as reinvested interest, right? This is what the concept of compound interest is all about; you basically get to earn interest on interest. 

When you continue reinvesting the interest that you earn on your deposits over a long period of time, you can essentially accelerate your wealth creation ability.  

How to calculate compound interest? 

Compound interest is calculated using the following formula - 

M = P [1 + (I÷N)]NT 

Here, M is maturity amount, P is the principal, I is the rate of interest, N is the frequency of compounding, and T is the time period. 

While you can calculate compound interest manually using the above formula, it is recommended that you use a compound interest formula calculator. This way, you can ensure that the result is accurate and free from error. Even banks routinely use daily compound interest calculators for calculating interest.   

What are the pros of compound interest?

Now that you know what compound interest is, let’s take a look at its advantages. 

1. It amplifies your returns

As you’ve already seen above, compound interest can amplify your return generation potential. How, you ask? Here’s an example. 

Let’s say that you wish to invest Rs. 1,00,000 for a period of 10 years at an interest rate of about 8% per annum. The frequency of compounding here is annual. At the end of 10 years, you will be left with Rs. 2,15,892. 

Compare this with simple interest, where you will only end up with Rs. 1,80,000. With compound interest, you get to earn Rs. 35,892 more than you do with simple interest. 

2.You can start off small 

Another major advantage of compound interest is the fact that you don’t have to start off with a large lump sum amount. Even minor investment amounts can give you high returns when given enough time. Here’s an example to help you understand. 

Let’s say that you start working at the age of 23. You invest 50% of your salary, which comes up to Rs. 10,000, in an investment option that gives you a return of about 8%. The compounding frequency is annual and you wish to hold the investment till your retirement age of 60. So, the tenure comes up to around 37 years. At the end of the investment period, you will be left with Rs. 1,72,456.  

What are the cons of compound interest?

In addition to providing benefits, compound interest also has a few disadvantages. Here’s a quick look at a couple of them. 

1. It is only advantageous over the long-term 

Compound interest works in your favour only when you give it a long period of time, say 10 or more years. It provides little to no advantage over the short-term. 

2. It can lead to significant financial burden 

Compound interest on borrowings or on debt can be very dangerous. When left unchecked, your debt can quickly spiral out of control, leaving you in financial ruin. 

Conclusion

As you can see, compound interest can be both advantageous and disadvantageous. Always remember to use a compound interest calculator when trying to determine the amount of interest that you’re likely to get. 

On the other hand, if you’re looking for alternative forms of investment, you could always invest in the stock market. If this is something that you might be interested in, get in touch with Motilal Oswal right away to open a demat account online. 

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