What is Compound Interest
The interest that is calculated on the principle amount that is invested, the resultant is then added back to the principle amount and compounded again. This amount is called the compound interest. This interest can be calculated on a daily, weekly or monthly basis, the more times this amount is compounded the more amount of money one can make.
If we leave the interest earned without removing the money from the account, the person will be making more money since the money you have earned is added back to the principle amount. In simple terms every time the interest is compounded the money earned gets added back to the total. Every financial institution will make it clear to the buyer as to how often would the interest be compounded. In other cases also they inform that only simple interest will be calculated on the principle amount.
There are two methods of calculating compound interest; one is the mathematical formula method and the other time chart method. First let us see the time chart method:
Let’s take an example of Rs. 100000 as the principle amount with an interest of 6% which is compounded annually for a period of 3 yrs. Now let’s start calculating the first year interest.
100000*.06 will be Rs. 6000 interest for the first year. Now we can see how the interest for the second year is calculated. Here the principle amount plus the first year interest will be added to calculate the second year interest. The process is explained below:
100000+6000= 106000*.06 will be Rs. 6360 this amount is called the compound interest on the principle amount. Now the third year interest calculation will be as follows:
Here the interest of the first and second year will be added back to the principle amount and on the sum total the compound interest will be calculated.
100000+6000+6360=112360*.06 will be Rs. 6742. So at the end of the third year we will have a principle amount of Rs. 119102, which has compounded to this extent. Now let’s see the mathematical way of calculating the compound interest. Many mathematicians have given their own formulas; let us take a simple formula for understanding it.
Principle amount * (1+rate) ^ N number of years. Now let us use the same numbers that we used for the time chart method.
100000*(1+.06) ^ 3 so when we calculate the ( 1+.06) ^ 3 we arrive at the expansion of ( 1.06+1.06+1.06) the resultant of this is 1.19 which is multiplied with the principle amount of Rs. 100000 which gives a value of Rs. 119100 which is rounded off for easy purpose. Hence compound interest is the result of interest being calculated not only on the principle amount, but also on the interest on the accrued interest. This type of interest is very profitable to commercial leanders since they make huge profits out of it.