Indians, today, are much more tech-savvy and financially literate than ever before. It is not surprising, then, that they are actively investing in the stock market and trading in other forms of equity-based instruments such as mutual funds, exchange-traded funds, etc. These forms of investments are reputed to help in building a long-term financial corpus by using the power of compounding.
When you invest your money in a financial instrument, you get a return on it. This simple interest is added to your principal and paid back to you when the investment tenure ends (like in a fixed deposit) or when you decide to liquidate it (like when you sell shares). In the case of compounded interest, not just your principal, but even your interest generates interest over it. In other words, your principal amount keeps increasing with each cycle, therefore, the interest you get also goes up. Compounded interest, significantly, accelerates your savings over the long term.
A = P (1+r/n)nt
This is the compound interest formula. Let us explain the variables involved in it.
A = the total value of your investment
P = the, initial, principal amount that has been invested in the financial instrument
r = the rate of interest
n = the frequency of compounding, or, the number of times the interest gets compounded
t = the total tenure the principal has been invested for
Let us see the compound interest formula in action using an example.
Let us assume you have invested a sum of ₹ 1L for a period of 5 years at an interest rate of 10% per annum. The interest is compounded half-yearly, which means there are two compounding periods per year. So, as per the compound interest formula, our equation will look something like this:
P = 1,00,000
r = 10% 0r 0.01
n = 2
t = 5
The total amount you can expect to receive at the end of this tenure is: 1,00,000 (1+0.01/2)2x5
which equals ₹ 1,62,889 and means a profit of ₹ 62,889.
Now that you know the compound interest formula, you can easily do the maths involved. However, it can be quite tedious to do manual calculations each time. Fortunately, you have online compound interest calculators that will do this job for you.
As mentioned, the compound interest calculator is an online tool that is quite convenient and easy to use. Just follow these steps:
That’s it. Your projected total amount (principal + interest) at the end of the period will be automatically displayed on the screen.
People prefer to invest in tools that utilise the power of compounding to grow their wealth manifold. This takes much longer in simple interest-based investment options such as a fixed deposit.
If you invest ₹ 1L for a period of 1 year at an interest rate of 10% per annum, in a financial product using simple interest calculation, then you will get ₹ 10,000 as interest. However, if you invest the same amount, for the same tenure, with the same interest in a product that uses compounded interest function, then you can expect to receive ₹ 10,471 (for monthly compounding), ₹ 10,381 (for quarterly compounding), and ₹ 10,250 (for half-yearly compounding).
As you can see, the higher the frequency of compounding, the more the returns you get.
This is why mutual funds and exchange-traded funds are some of the most preferred investment options today. They use the compound interest formula to raise wealth for your future goals. The added convenience of investing in lump sum or as convenient monthly installments (SIP) further help you financial cause. The longer you remain invested the more compounding periods your capital goes through. This is the main underlying principle that leads to wealth creation.
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