The Complete Beginner’s Guide to Interests and Its Calculation

If you are depositing a certain amount of money in the bank or borrowing money from it or from somewhere else, you need to pay or get a certain amount of money in addition to your principal.

But if you are not aware of the interest you might be defrauded and can face certain problems in your life. 

So you should have the proper idea about interest, especially about Compound interest as it is a little bit complex and not too confusing about the interest amount while paying or taking. 

So let’s dive into the article below, and find out all your queries about Compound interest and how to calculate it.

But before, you should have the basic knowledge about interests. So let’s find out that beforehand. 

What is interest?

In economics and finance, interest refers to the payment from a borrower or deposit-taking financial institution to a lender or depositor on an amount above repayment of the principal sum, at a particular rate of interest.

For example, if you are depositing some amount of money in your bank account,  it will give you some amount of extra money in addition to your principal deposit. 

Interest is generally calculated as a percentage of a deposit balance or a loan amount that is to be paid to the lender periodically for the privilege of using their money.

Types of interest 

There are several methods to calculate interest. But there are two major types of interest that are used in finance and economics to calculate the interest amount to be paid or to be gained. The two types of interest are

1. Simple interest 
2. Compound interest 

Simple interest 

Simple interest is usually calculated using a fixed rate of interest expressed in percentage terms, that is charged against the principal amount of debt or outstanding amount at defined periods. Therefore, it is very particularly easy to calculate the simple interest at regular intervals of time. The lender has more certainty on the required amount of future loan repayments or investment returns. Simple interest is more simple and generally means the absence of compounding.

The simple interest formula to calculate the interest rate is 

                            I= P*R*T / 100

            Where I= Interest amount 

           P= principal 

           R= Rate of interest 

           T= Time

The total amount of money to be paid along with the interest can be calculated as the 

               A= P+I

Compound interest 

Compound interest or otherwise named the compounding interest is the interest amount on a loan or deposit that is calculated based on both the initial principal and the accumulated interest on that principal from previous periods. So in the short term, it can be said that Compound interest is “interest on interest”.

Compound interest grows at a faster rate than that of simple interest which is calculated only on the principal amount. 

The rate at which the compound interest accrues depends on the frequency of compounding periods the higher the number of compounding periods, the greater the compound interest to be paid. Because the interest-on-interest effect or commonly known as compound interest can generate increasingly positive returns than the simple interest based on the initial principal amount.

So this  compounding has sometimes been referred to as the “miracle of compound interest.”

How does compound interest work?

To understand compound interest better, let’s start with an example.  We can simply first understand the concept of simple interest. Let you deposit a certain amount of money in the bank, and the bank pays you interest on your deposit.

For example, if you deposit 10,000 rupees in a bank and earn 5% annual interest, a deposit of 10,000 would gain you 500 after a year. But, what happens the following year? That’s where the compound interest comes in. You earned the interest on your initial deposit, and after that, you will earn interest on the interest you just earned.

The interest your money earns in the second year will be more than the previous year because your account balance is now 10,500, not 10,000. Thus the interest from the next year will be calculated at 10,500.

The above is an example of the interest that compounds yearly. At many banks, including online banks, the interest compounds daily, and compound interest is calculated on daily basis and gets added to your account monthly, so the process moves even more rapidly. 

Just like you charge compound interest, if you are borrowing money from anyone, compounding can also work against you and in favor of your lender instead. So you need to pay interest on the money that you have borrowed. The next month, if you haven’t paid the amount that you have owed in full, you will owe interest on the amount that you have borrowed plus the interest you’ve accrued. 

How to calculate compound interest?

Compound interest is very easy to calculate.  Through this formula,  you can know the amount of money you have to pay or take for a certain period of time. 

But before that, you need to know,

1. The principal amount that you have borrowed or deposited
2. The rate of interest 
3.  The number of times your interest will get compounded per year.
4. The number of years that you have taken the money. 

Once you get these above figures, you can calculate the compound interest by a simple formula which is given below,

                      A = P (1+r/n)nt

Where,

A= Total amount of money to be paid or gained 

P= principal amount of money 

r= Rate of interest 

n= number of times the interest gets compounded per year 

t= number of periods the money is invested for 

Let’s take an example for your better understanding,

Let’s assume you have borrowed INR 10,000 for 10 years. You should pay 5% interest on your borrowed money and your interest gets compounded annually. Then calculate the compound interest using the given formula.

So, if you calculate verbally, you have to pay INR 500 on your borrowing money of INR 10,000 in the first year. So, your principal amount changes to INR 10,500 in the following year. You can now earn INR 525 as the interest amount on your new principal amount of a total sum of 10,500 + 525 = 11,025. It often gets confused and a little bit clumsy to calculate. 

But  If you use the formula above, you can quickly understand how much you will have at the end of ten years in a fraction of a second.

So given that

P= 10,000

R= 0.05

t= 10

n=1

So as per the formula,

A = 10000 (1 + 0.05/1)10 = INR 16,288.95

Thus you can earn INR 6,288.25 as an interest amount. 

Concluding thoughts

As you have read the article this far, you don’t have any dilemma regarding compound interest. 

Compound interest is the method of interest that compounds regularly and can supercharge your savings and retirement potential. Successful compounding can let you use less of your own money to reach your goals and earn more in a little time 

However, sometimes compounding can also work against you like when you have borrowed the money, high-interest credit card debt builds on itself over time. 

That’s why compound interest is referred to as a powerful motivator to pay off all your debts as soon as you can and start investing and saving your money early.

*image source from Google

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