Learning about the basics of simple and compound interest may seem like a silly exercise best suited for students. But knowing the basics is important for retail investors because you will get a clear picture of how doing long term investments will quadruple your revenue by manifolds. But before we can break down these seemingly complicated concepts for you, let’s get the basic definitions out of the way.
SI is the amount added to a principal amount of money for a specific period.
Compound Interest is calculated on the principal amount along with accumulated interest on multiple smaller periods of time.
The fundamental difference – Here’s what you need to know
The major difference between the two depends on what it’s based on.
- SI is based solely on the principal amount involved for a loan or investment.
- Whereas the compound interest is added on the principal amount ‘combined’ with the interest compounded for one cycle of the total period on the loan or investment. Here, the word ‘combined’ is key since ‘compound’ literally means to mix several parts or elements.
In simple words, the returns on CI are much higher than what a simple interest pays.
Understanding Simple Interest and Compound Interest in Daily Life
SI, as the name implies is simply added on to the original loan or investment amount. On the other hand, CI is ‘accumulated’ and is hence much more profitable for the lender or investor.
Whenever an interest is added to a sum, the value of the money doesn’t stay the same over time. It grows periodically, and that is precisely why these concepts are so important for an investor looking to grow their money.
Must-know basic formulae
Here are the two basic formulae for calculating both SI and CI. These are the ‘first-to-know’ basics to be aware about before moving ahead to complex, in-depth calculations pertaining to your investments.
P = Principal Amount
Rate = Rate of Interest
T = Time Period
A simple example
Let’s consider a principal investment amount of INR 5 Lakh. At a rate of 30% for a period of 30 years, what is the money you would possess at the end of 30 years? With a basic SI calculation using the formula mentioned above, you will possess 45 Lakh rupees + principal amount = INR 50 Lakhs in total.
On the other hand, if CI is added to your investment, the numbers achieved are mind blowing. For the same figures and the problem statement mentioned above, you can achieve an approximate revenue of INR 130 Cr on the same principal amount of INR 5 Lakhs.
The compelling power of compounding
The reason why compound interest is so significant for an investor is because it’s a scenario where ‘interest earns interest’. Thus, your earnings grow and multiply at a constant yet faster rate. Here are some factors that demonstrate the compelling power of compounding:
- Depending on the compounding frequency, your investment returns consequently improve.
- Your interest earns higher interest through the year.
- By staying invested, your returns significantly become higher and higher in the long term.
The 8th Wonder and the Rule of 72
Albert Einstein referred to CI as the ‘8th Wonder of the World’ for all the right reasons. Compounding is best suited for long-term investing. To understand this, let’s explore the ‘Rule of 72’:
The Rule of 72 is a concept that indicates how your money doubles in compounding. For your investment, calculate the number of years it would take for your money to double using the Rule of 72.
Here’s the simple formula for calculation:
Number of years for your money to double = 72/ROI.
Let’s say your rate of return = 10%
Therefore, Number of years for your money to double = 72/10 = 7.2 years.
Albert Einstein referred to Compound Interest as the ‘8th Wonder of the World’ for all the right reasons.
Enter the world of investment
Now that we have a fair idea about interest and how it can make an impact on your principal investments, you can explore the technicalities of interest accumulation and wealth creation. With a step-by-step understanding, you can build your knowledge which will come in handy when you begin to explore the stock market.