Compound Interest Definition:
Most important topic always discussed in the financial world is ‘power of compounding’. When we are selecting investment on returns based on a year, A small fraction of change will impact a huge change when calculation for a longer period of time. This is because interest earn get reinvested periodically with your capital investment this is where the power is stored when computing compound interest.
Compound Interest Formula:
Future Value = [Principal Amount * (1+ Interest Rate)] ^ Power(Number of Years)
Example of Compound Interest:
Let us take an example to understand the compound interest calculations:
Mr. Jhon plans to invest Rs.3,00,000 (around $4,600) in stocks with 10% returns per annum for next 20 years. What would be the future value of the investment after 10 years.
Let us evaluate:
FV = [P * (1+R)] ^ Power(N)
FV = [3,00,000 * (1 + 10 / 100)] ^ Power(20)
FV = [3,00,000 * (1.1)] ^ Power(20)
FV = Rs.20,18,250/-
Result: Mr. Jhon is intend to earn Rs.20,18,250/- (around $31,050) at 10% rate of interest for 20 years with compounding interest.
Simple Interest Definition:
Simple returns or simple interest means returns earned on your capital investment year on year without reinvesting the interest income earned for the period. This is mainly calculated to evaluate short term financial returns on the investment.
Simple Interest Formula:
Simple Interest = [(FV / P) – 1] Where, P = Principal / capital amount of investment and FV = Future value or the amount expected to be received in short term.
Example of Simple Interest:
Let us take an example to understand the simple interest calculations:
Mr. Jhon speaks to the bank representative for schemes to invest in fixed deposit account. Mr. Jhon decides to invest Rs.1,30,000/- (around $2000) for a year when he is expecting to earn Rs.1,43,000/- (around $2200). Let us calculate what is the percentage return plan offered by bank representative.
Let us evaluate:
Simple interest percentage = [(FV / P) – 1] * 100
= [(1,43,000 / 1,30,000) – 1)] * 100
= [1.10 – 1] * 100
= 0.10 * 100 = 10%
Result: Mr. Jhon is intend to earn 10% of returns for his fixed deposit investment for a period of one year at simple interest calculation.
Difference Between Simple Interest and Compound Interest:
Suppose we take the same above example than we see than Mr.Jhon thru compounding interest earned Rs.20,18,250/- (around $31,050) at 10% for 20 years after investing Rs.3,00,000/- with same scenario when we calculate the same using simple interest we notice that Mr.John earns Rs.9,00,000/- (around $13,846) which is even less than half of the compound interest earnings. This is where the major difference between simple and compound interest when evaluated.
This brings us to understand the mortal power of multiplication. Compounding returns turns to be the best planning measures for long term investment returns. This is the key element one should hold some of the investment for your long term goals when selecting investment options or investment plans. This can be proven as one of your best investment strategy.
- Tutorial Course - Basics of Investing for Beginners -
» e-Learning Chapter 1: What is Investment and its objectives.
» e-Learning Chapter 2: Why is Investment important for Economic growth.
» e-Learning Chapter 3: Ways to Invest your money and make profit.
» e-Learning Chapter 4: What are the Best Investment Opportunities for your Retirement Income.
» e-Learning Chapter 5: What are the Legal Matters you should know before Investing.
» e-Learning Chapter 6: Different Types of Investment Risks Involved in Investing.
» e-Learning Chapter 7: When and How to Invest in Stocks.
» e-Learning Chapter 8: How Positive Attitude can improve your Investing mindset.
» e-Learning Chapter 9: Should you Borrow Money to Invest in Stock Markets or Funds.
» e-Learning Chapter 10: 5 Rules of Thumb: Key points to be consider before making Investments.
» e-Learning Chapter 11: How to Calculate Stock Market Returns, Break Even Point and Basis Point.
» Currently Reading: How to Calculate Compound Interest and Simple Interest.
» e-Learning Chapter 13: Rule of 72, 114 and 144 of Compounding Interest formula.
» e-Learning Chapter 14: What is the Difference between Trading, Investment and Speculation?
» e-Learning Chapter 15: How to become a Smart Investor or a Successful Investor.
» e-Learning Chapter 16: Tutorial Quiz – Basics of Investing for Beginners Module.