IN FINANCE, INTEREST SHOULD ONLY MEAN COMPOUND INTEREST
Interest is interest, right? Well actually, no, it isn’t. There’s a BIG difference between simple and compound interest.
As an investor it is high time you understand the difference between simple & compound interest.
Simple interest is where the amount of interest generated each term is constant, based on only the starting amount.
Compound interest is where the amount of interest generated each term increases because it is based on both the starting amount and previously earned interest.
Compound interest sounds more complicated than it really is. In a nutshell, compound interest is making money off of the money you already made, or interest off the interest you’ve already made.
Simple Interest vs. Compound Interest
How much of a difference can this really make? Well, take a look at this chart. It assumes that you put Rs. 1, 00, 000 in the bank today and that your account earns 8% interest annually. You won’t have to put any more money in the bank after today; this chart just shows the work interest does.
Series 1 stands for working of simple interest. Here, every year your money would earn Rs.8000, so after 25 years; you would have earned a total of Rs. 2, 00, 000 as interest. (This 2, 00, 000 is difference between the final value of
3, 00, 000 & the original investment of 1, 00, 000)
Series 2 stands for working of compound interest. Here, every year your money would earn interest not only on the principal but also on the interest earned till that date. So after 25 years you would have earned a total of Rs. 5, 84, 848 as interest. (This 5, 84, 848 is the difference between final value of 6, 84, 848 &
the original investment of 1, 00, 000)
We can conclude that if you would have invested in an investment avenue paying interest at compounded rate you would have earned Rs 3, 84, 848 (5, 84, 848 - 2, 00, 000) more at the end of 25 years.
Magic of compounding.
Compound interest has been called the eighth wonder of the world. And with good reason. It magically turns a little bit of money, invested wisely, into a whole lot of cash. Even Albert Einstein — is said to have called it one of the greatest mathematical concepts of our time.
Above we saw that yearly compounding gives sparkling returns. If this compounding was done semi annually, quarterly or monthly then the returns earned would have been all the more mind boggling. In the chart above we assumed compound interest 8% p.a. If we consider the option of compounding semi-annually, quarterly or monthly, then the actual rate of compounding would turn out to be 8.16% p.a., 8.24% p.a. or 8.30% p.a. respectively. So the total interest earned in these scenarios would be Rs. 6, 10, 668, Rs. 6, 23, 926 or Rs. 6, 34, 026
Another important reason for writing this article is to educate you regarding returns given by various products these days.
Due to market crash you might have moved towards secured investments. These secured investments give “GUARANTEED RETURNS”. The rates they offer seem to be highly attractive. But you may fail to notice simple interest written in fine print. Even if you note it, you may not be able to comprehend how different it is from compound interest.
Let’s take an illustration to clarify this.
Suppose an investment product like a Fixed Deposit comes up in the market whose terms are as follows:
Rate of interest: 10% p.a.
Term: 5 years
Initial investment: Rs. 10, 000
Amount you get after 5 years: Rs. 16, 105.
(Assuming interest is reinvested)
The product may say that on cumulative basis you earn 12.21%.
You think 12.21% in this scenario is good. But wait a minute, My dear friend!
This 12.21% is on simple interest basis. It is calculated as follows:
Interest = (((16105-10000)/10000) / 5) * 100
=12.21%
This is wrong way of calculating interest you would earn!!!!
In reality, you earn only 10% on compound interest basis.
If you see 12.21% on compounded basis you should get Rs. 17, 789. But you get only Rs. 16, 105.
So the bottomline is, READ THE OFFER DOCUMENT CAREFULLY BEFORE INVESTING & invest only looking at the compound rate of interest not at cumulative or simple rates.
