Compound interest is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. This means that the interest earned in one period is added to the principal, so that the interest earned in the next period is based on a higher amount. This process compounds over time, leading to significant growth in the amount of the loan or deposit.
In the case of savings, compound interest can work to your advantage. For example, let’s say you deposit 10,000 rupees into a savings account that earns 5% interest per year, compounded annually. After one year, you would earn 500 rupees in interest, for a total balance of 10,500 rupees. In the second year, you would earn an additional 262.5 rupees in interest (5% of the new balance of 10,500 rupees), for a total balance of 10,762.5 rupees. In the third year, you would earn an additional 538.13 rupees in interest, for a total balance of 11,300.63 rupees. This process continues, with the interest earned in each period adding to the balance and earning interest itself in the next period.
In the case of loans, compound interest can work against you. For example, let’s say you take out a loan of 10,000 rupees at an interest rate of 10% per year, compounded annually. After one year, you would owe 11,000 rupees (the original 10,000 plus 1,000 in interest). In the second year, you would owe 12,100 rupees (the original 10,000 plus 1,000 in interest from the first year, plus an additional 1,100 in interest on the new balance). In the third year, you would owe 13,310 rupees (the original 10,000 plus 1,000 in interest from the first year, plus 1,100 in interest from the second year, plus an additional 1,210 in interest on the new balance). This process continues, with the interest adding to the balance and earning interest itself in the next period.
To understand this better, we can take an example of an individual who invest Rs. 100,000 at an interest rate of 8% per annum for 10 years. The compound interest will be calculated as follows:
| Year | Principal | Interest | Total |
|---|---|---|---|
| 1 | 100,000 | 8,000 | 108,000 |
| 2 | 108,000 | 8,640 | 116,640 |
| 3 | 116,640 | 9,331.20 | 125,971.20 |
| 4 | 125,971.20 | 10,077.69 | 135,048.89 |
| 5 | 135,048.89 | 10,803.91 | 145,852.80 |
| 6 | 145,852.80 | 11,608.22 | 157,460.02 |
| 7 | 157,460.02 | 12,396.81 | 169,856.83 |
| 8 | 169,856.83 | 13,268.54 | 183,125.37 |
| 9 | 183,125.37 | 14,250.03 | 197,375.40 |
| 10 | 197,375.40 | 15,390.03 | 212,765.43 |
As we can see, the interest keeps on compounding with the principle and the individual gets a final amount of Rs. 212,765.43 after 10 years.