The compounding concept is advantageous for lending and borrowing in the financial sector. Simple and other advanced formulae such as the compound interest rate formula are mainly used by banks/financial participants to determine interest liability or income.
What does compound interest mean?
The compound interest of a financial asset is interest over interest. Here is an example to clarify this concept or the compound interest rate formula. With an annual compounding repo rate of 10%, you have deposited Rs. 1000 over 2 years. To explain this, imagine calculating the interest on Rs. 1000 with a 10% rate of interest so that you will earn Rs. 100 on Rs. 1000 for the first year.
(Deposit plus interest) Rs. 1,100 would be the principal amount for the second year. There would be Rs. 110 in interest for the second year. Here is an example of compound interest, which shows an interest of Rs 100 earned on a deposited amount and then Rs. 10 was earned on the interest of Rs. 100 that was previously earned.
What are the methods of calculating?
It would help if you use the following formulas to determine this interest:
1. First, determine the accumulated amount for the overall period, which is the sum of deposited amounts and interest earned.
Accumulated amount= Principal amount [1+annual interest rate] ^ time
2. Then, interest can be calculated using the following formula:
Compound interest=Accumulated amount - Principal amount
Advantages of Compound Interest
It is more advantageous than simple interest because it provides access to earning interest on previously earned interest. In loans, it increases the value of loans, resulting in an advantage for lending firms. Lenders and financiers compute interest values and future money values throughout the financial industry using the compounding method.
Take another example, for instance. You'll receive interest on your deposits in a savings account or similar account when you deposit money. You would receive Rs 50 in interest after a year by putting Rs 1,000 into an account paying 5 percent interest.
You earn compound interest when you earn interest on interest. Therefore, in the example above, you would earn 5 percent of Rs 1050 in interest payments in year two, or Rs 52.5. Compound interest allows your savings to quickly grow because it accelerates the interest earnings.
As the account balance increases thanks to the interest earned in prior years, you'll earn interest on larger and larger amounts. Your interest earnings can snowball very quickly if you use compound interest over the long run, and it can help you build wealth.
Investments and savings accounts, as well as money market accounts, pay interest. The interest payable on an investment or a savings account is determined according to a period- daily, monthly, every six months, or even a year.
You'll earn additional interest on your deposits in these accounts, compounding the interest you earn. Interest compounds according to the account's schedule. Interest might be compounded daily, weekly, or monthly in a basic saving account.
Aman Khanna is an experienced financial advisor who is well known for his ability to foretell the market trends as well as for his financial astuteness. He has an MBA in finance from Toronto University as well as years of experience delivering seminars on sound financial practices and debt management.