Compound interest sounds very interesting as a concept when we are trying to make money. It is literally concerned with letting your money multiply on its own.
The concept of compound interest can seem a little vague to some and can be broken down into a simpler idea. The money you invest functions as a principal amount on which you earn interest. The accumulated interest added to your principal sum becomes a larger sum on which you earn a larger amount of interest.
In other words, the compounded amount accrues greater returns.
How to calculate compound interest?
What is the easiest way to solve compound interest questions?
How does compound interest work?
What are the pros of compound interest?
Is compound interest the best investment?
These are some common questions you might find asking yourself whether you are trying to make some financial goals or even if it is a simple commercial math problem that you are trying to solve. It also happens to be one of the very basic and important concepts you must understand when making any kind of investment.
1. Simple Interest vs Compound Interest
The terms simple and compound interest go together. One is most often compared against the other when it comes to weighing the benefits of one over the other. Any interest accumulated on a principal amount that remains fixed is simple interest. When the interest gets accumulated with the principal amount, the interest earned on it is compound interest.
This makes compound interest earn a greater return on your invested sum of money.
At the same time, it’s not the ideal situation if it is the kind of interest you need to pay on your loan. So, the pros of compound interest over simple interest would depend on whether you’re a borrower or a lender.
The good and the bad: you earn more returns on investments through compound interest. You accumulate more debt substantially on loans and credit cards.
2. Why is Compound Interest Better than Your Typical Savings Account Interest?
Savings accounts are typically low-risk investments. In fact, the rate of investment is so low that there is hardly much to benefit from it. It serves the purpose of what it is named: ‘savings’. The return on that savings is usually negligible, and it is therefore recommended that people invest it in the form of Fixed Deposits, recurring deposits and other forms of investment.
A quick calculation from any online interest rate calculator would give you an estimate of your returns based on the money you wish to set aside and the time period for it. These calculators come in handy for a quick guide to understand how fast your wealth is capable of growing through different investment avenues.
A quick glance at any of these estimates will tell you that a compound interest style investment is better than your typical savings account, simply because of the rate of return.
3. How to Explain the Pros of Compound Interest to Children?
When explaining the concept of compound interest to children, formulae can only get you so far. They’ll just be numbers and calculations. But to explain the true advantage that compound interest has and how it benefits us can be explained through a simple concept that we discussed in the very beginning.
- You set aside money for savings.
- You earn some interest on the savings; explaining the simple concept of earning interest becomes easier when they are aware of percentages).
- The interest earned is added to the savings.
- The new amount then earns more interest at the same rate.
- Money builds more money.
Kid-friendly definitions are the best way to explain the concept of compound interest and often come in handy even when explaining to adults.
Make learning fun: Once you have explained the concept clearly, incorporate some fun element to the process of learning this concept of commercial math. Give them real figures from your bank or deposits and allow them to calculate it. This not only makes learning fun but also allows them to apply a more bookish concept and formula of compound interest in a real-life scenario.
If they are younger and real bank statements seem too daunting, opt for a change jar and teach them the concept of compounding with some real change allowing them to earn some pocket money as they get the concept right.
These are also good ways to get children into the habit of saving from an early age. It is also one of the many essential factors behind your rate of return on investment.
4. Compound Interest in Real Life
Commercial math done at school is a lot different from what we actually apply in our daily lives. CAGR or compound annual growth rate is a common financial application of compound interest calculation. This is a concept used in the stock market and mutual funds to calculate an average return on your total investment. It gives people the advantage of estimating an expected rate of return, growth, and their own risk appetite.
In most cases, when it comes to the stock market, additional investments from profits or dividends accrued can be made, which is then called a reinvestment. Dividend investments reap the same (if not more) benefits as the compound interest that applies a similar principle of calculation while being subject to market fluctuations and risks.
5. Can You Benefit from Compound Interest?
Any investors planning to multiply their wealth will see the many benefits of compound interest. Individual investors will do this through fixed deposits, term deposits and mutual fund or stock market investments.
Banks and financial institutions too, benefit from compound interest through their bonds, loans and money-lending facilities. Compound interest thus as a concept and its pros are not limited to the traditional form of interest from accounts and deposits alone.
6. Time of Investment
The real pros of compound interest lay in the time when you invest your money. Since the interest accumulated gets added to the principal amount, compound interest has greater returns, the earlier you start investing.
For instance, if Ravi starts saving Rs.5000 every year from the age of 22, he will have accumulated more wealth when he reaches the age of 60 compared to another person, say who has started saving the same sum from the age of 32. It is not just the sum of 10 years that he misses out on, but also the accumulated interest that he would have gained in that period. Accrual of interest would also depend on what frequency or compounding interval you would like to invest.
The usual compounding interval for most Indian banks is monthly, quarterly, semi-annually, and annually. The rate of interest also varies depending on the interval period.
7. Reaping the Benefits of Compound Interest
One of the popular and easy ways to benefit from the application of compound interest in our daily investments is through mutual funds. Dividends and returns earned from mutual funds are easy to reinvest and have comparatively lower risk value as compared to investing in the stock market.
Over the years, greater number of investments and purchase of shares will yield greater results.
8. Build Your Savings Early
From all the factors, benefits and downsides discussed above, compound interest is one of those rules you should apply to estimate and build your savings from an early age. It should serve as a motivation for anyone planning to build wealth and become financially stable when they retire.
Teaching children about commercial math through interests, investments, and savings prepares them to be more financially independent and keep track of their expenditure and savings in a better and efficient way.
When you plan out your financial goals, ask these three simple questions to yourself that would help you plan out your goals:
How much can I invest?
For how long can I stay invested?
What is the rate of return I expect?
These simple questions can not only give you an estimate of how much you should or can invest, but also help you set a financial target for yourself from an early age and start saving accordingly.
9. Understanding and Learning to Put Compound Interest Concepts to Use
There are various factors and aspects of compound interest that you can learn and apply in your daily life for calculating returns on investments. It is a useful skill to have so that we understand commercial math and be able to use the same for making better financial decisions. The key to building wealth lies at the root of compound interest, and it is one of these basic concepts that allow you to watch your wealth grow exponentially.