Compound Interest : Math Basics

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein

You gotta take compound interest seriously if Albert Einstein says so, isn’t it? Anyway, compound interest is that magic calculation which helps a number of investors across the globe rake in great profits on their initial investments.

The simplest way to understand compound interest is that it is “interest on interest”, which will make any amount grow faster than simple interest. Compound interest is the interest calculated on the initial investment or deposit and also on all the consolidated interest of all the previous periods. Also, known as compounding, its rate depends on the number of periods. Obviously, higher the period, greater will be the compound interest.

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Let us understand compound interest with a simple contrast. Suppose you have $100 in your bank account. Suppose the bank gives you 5% interest on the amount every month. You will have $100 in the first month, $105 in the second month, $110 in the third month, $115 in the fourth month, $120 in the fifth and so on. In this case, the bank calculates the value based on the initial investment. This is an example of simple interest.

Now, suppose the same bank takes into account the total bank balance (principal+interest) to calculate the interest. In this case, you have $100 in the first month, $105 in the second month, $110.25 in the third, $115.76 in the fourth, $121.55 in the fifth and so on. When you keep on compounding, the number multiplies quickly with growing interest. Naturally, the amount accrued through simple interest over a long term say 5 years will be much lesser than the compound interest in the same period. That is why investors are often advised to invest longer to benefit from the power of compounding.

Compound Interest Formula

To calculate compound interest, you have to simply use this simple formula:

F=P (1+i/n)nt

Where F represents future value, P represents present value, i stands for nominal interest rate, n stands for the compounding frequency and t signifies total time.

To determine the total compound interest gained,

Compound Interest = F-P

Now attempt a few practice questions to test your preparation.

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