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Compound Interest Formula: Definition, Advantages And Disadvantages
The compound interest formula is the interest acquired on savings that is calculated based on both the starting principal and the accumulated principal from the time previously.
Basically, the compound interest formula works on the principle ?interest on interests,? which makes a sum grow way faster than a simple interest. A simple interest is only calculated over the principal amount.
The compound interest formula multiplies the sum that you put in at an accelerated rate. This means with greater compounding period numbers, you will accumulate a greater amount of compound interest.
However, as exciting compound interest may seem to help with your investments, there are high chances that it will make debts even more difficult for you.
So, without any further delay, let us understand the concept of the compound interest formula and figure out if it is worthy of investment.
Key Takeaways
- The compound interest formula multiplies the funds at an accelerated rate.
- While simple interest only calculates itself over the principal deposit amount, compound interest calculates both the principal amount and the interests accumulated over the previous compounding periods.
- The main power of compound interest circulates on the principal saying, ?interest on interest.?
- The interests are compounded on a daily, annual, or continuous frequency schedule.
What Is Compound Interest?
As I have mentioned before, compound interest is a category of interest that is calculated both on the principal amount and the interest that is accumulated over the previous compounding periods.
Compound interest differs majorly from simple interest. While calculating simple interest, the interest of the previous periods is not added to the principal amount for the next period.
In the case of mathematics, the compound interest is denoted as CI.
While the compound interest formula holds its authority in relation to financial and banking sectors, there are certain other areas where the same is applied, too. Such areas may include:
- An increase or decrease in the rate of population.
- Bacterial growth.
- An increase or depreciation in the value of items like properties or cars, respectively.
How Does Compound Interest Work
Understanding how compound interest operates may not be as complicated as it looks. In fact, it is way easier than you would think it to be.
To calculate compound interest, you need to multiply the principal amount that you had initially invested by one, plus the annual rate of interest raised, by the total number of compounding periods minus one.
The total principal or the loan amount is then deducted from the resulting value.
Formula For Compound Interest
Let us now see how to calculate compound interest in the easiest way possible. As I have mentioned before, the compound interest formula is not rocket science. Initially, it may seem a little complicated; however, that gets easier once you have understood it entirely and have done the calculations a couple of times over.
The compound interest formula, therefore, is –
Compound Interest = Amount – Principal
Here, the mentioned amount is gotten by –
A = P(1 + r/n)nt
Where,
- A is referred to the amount.
- P is the principal.
- r is the rate of interest.
- n is the amount of time the interest was compounded each year.
- t refers to the time in years.
You may also write the formula alternatively as given below:
CI = A – P,
And,
CI = P( 1 + r/n )nt – P
This formula is also known as the Periodic Compounding Formula.
Here,
- A refers to the new principal sum or the total sum of money accumulated once a compounding period is over.
- P is the initial or the original amount.
- r is the annual rate of interest.
- n is the compounding frequency or the total number of times the interest compounds in a year.
- t is the representation of the total years in question.
However, this formula is only general and should be applied in a case where the principal is compounded many times within a year. In case of an annual compounding of the interest, the undermentioned formula is to be used:
A = P( 1 R/100)t
Therefore, it is evident that the compound interest formula can be used for multiple scenarios, like compounding on a yearly, quarterly, half-yearly, monthly, or daily basis.
Pros And Cons Of Compound Interest Formula
While there are pros of compound interest, it has its own cons, too. Let us now see what the pros and cons of compound interest formula might be:
Pros
- It is very beneficial for investments and savings in the long term.
- Eliminates the risks of wealth erosion
- Compounding is a better option when you are repaying loans.
Cons
- It works against the consumers by making minimum payments over higher interest loans or credit debts.
- The interest returns are also taxable.
- At the initial stages, calculating a compound interest formula can be extremely complicated.
Explained Advantages Of Compound Interest
It is very beneficial for investments and savings in the long term: Compounding may work to your benefit when it comes to savings and investments, as you earn a return on your returns.
Eliminates the risks of wealth erosion: The exponential growth of compound interest is also vital in diminishing the wealth erosion factors, like a rise in the cost of living or a reduction in purchasing power due to inflation.
Compounding is a better option when you are repaying loans: When you are making more than the minimum payment, you can support the compounding power to save on the entire interest.
Explained Disadvantages Of Compound Interest
It works against the consumers by making minimum payments over higher interest loans or credit debts: If you are only paying the minimum, your balance may continue to grow exponentially due to the compounding interest. This can easily trap people in a ?debt cycle.?
The interest returns are also taxable: The money that you are earning from your compound interest falls under the tax bracket unless you keep the money in a tax-sheltered account.
At the initial stages, calculating a compound interest formula can be extremely complicated: Calculating the simple interest is comparatively easy compared to a typical compound interest formula. Compound interest calculators require more use of maths; therefore, it is always better to use an online calculator.
The Bottom Line
Compound interest is one of the easiest and most convenient ways to increase your money over time. With its power to provide you with ?interest on interests,? you can easily multiply your funds in no time.
For money-making purposes, the compound interest formula is always a better preference compared to a simple interest formula. However, the compound interest formula in itself can be quite complicated to learn and has some notable disadvantages, too.
Therefore, I will always suggest getting in touch with an expert before investing your money in either of the accounts, as they will help to better guide you effectively and will give you a way out for the greater good of your financial health.
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