Compound interest refers to adding of the interest to the principal to make sure that the former (interest) which is added even earns interest. Compounding refers to this process of adding interest to the principal. In case of a loan, interest may be compounded each month. For an example – suppose you take up a loan of the amount $100 which is the initial principal. Having 1% interest every month would result in a balance of $101 towards the end of the starting month, $102.01 at the second month’s end and will continue this way henceforth.
Compound interest is different from simple interest in the sense that in the latter case, interest is not compounded with the principal. Compound interest is taken as a standard in economics and finance while simple interest is used relatively infrequently.
Importance of compound interest
It will be apt to state a quote by Albert Einstein at this juncture. "Man's greatest invention is compound interest". Money grows all on its own through compound interest. Making use of compound interest entails that you do not have to work for the money; rather that money will do the work for you.
An example will make the conception clear. Suppose you have $10000 at your disposal. You may place the cash on an investment plan which gives you yearly interest of 10%. In this way, you will get $1000 per year and if you take out that money for using it, you will have the same $10000 left. Suppose you decide to keep that $10000 allowing it to grow, you will find that the amount has increased to $25,938 after 10 years, and after 15 years the total amount is $41,772. Thus compound interest has doubled your money which would not have been the case if you had taken yearly interest. Compound interest thus makes you earn much more than simply saving your money.
You are not taking any risks by using the power of this form of interest. You have to be just aware of the technique of using compound interest to your advantage. The key is the amount of capital money as well as the time. The more amount of time you leave the money to grow and put in more, the higher will your final amount be.
Formula used for calculating compound interest
Compound interest formula is M = P (1 + i) n. M refers to the final or total amount inclusive of the principal. P is the principal, and i is the interest rate per year.
Let us suppose we have $1000 for investing up to three years at 5% compound interest. Applying the formula - M = 1000 (1 + 0.05)3 = $1157.62.
Compound interest is certainly a good way to make profit without putting in much effort. However if you are at the paying end relating to compound interest, you are in for troubles. Credit card companies make use of compound interest. Thus with every passing year credit card debt will multiply. To avoid such a situation you should try and pay off your debts as quickly as possible.