What Is Compound Interest?
When an investor earns interest on the principal amount along with the interest it incurs, it is called compound interest. Let’s say you invest Rs. 10,000 in a fixed deposit for 2 years at an interest rate of 9% and opt to redeem the interest directly at maturity. During your first year, you accrue Rs. 900 in interest. But in your second year, you accrue 9% interest on Rs. 10,900, which comprises the principal amount plus the interest generated in the first year.
What is the Power of Compounding in Mutual Funds?
Warren Buffett, chairman of Berkshire Hathaway and one of the most successful value investors in the current era, made 99% of his wealth after the age of 65, making him one of the richest people in the world. Such is the power of compounding. Compound interest is a tool that investors use for financial planning and to potentially build wealth in the long run. The longer one stays invested, the better is the possibility of leveraging the power of compounding.
Additionally, compounding in mutual funds lets you earn returns on returns, and when reinvested back into the mutual funds, it may lead to potentially exponential growth over the years. Under the growth option in a mutual fund investment, the earnings are reinvested into the mutual fund, leading to a snowballing effect on the overall corpus.
What Is a Compound Interest Calculator?
Often, small changes in investing habits may lead to a significant difference in the wealth created over a long-term horizon. However, sometimes, it may be difficult for an investor to comprehend the effects of such changes in the interest calculations, especially when considering a timeframe that spans decades. A compound interest calculator is useful in this situation. It is a handy financial tool that lets you capture the effect of potential compounding on your investments by letting you incorporate various inputs like the interest rate, principal amount, investment period, and compounding frequency.
Thus, a compound interest calculator is a useful tool that can help you to grasp the impact of potential compounding on your investments over a period of time, by inputting a few details.
How Does a Compound Interest Calculator Work?
A compound interest calculator gives the amount of compound interest accumulated after a period of time, by factoring in inputs about the investment. Let’s understand step by step as to how it works.
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You input the initial principal amount, the assumed rate of return, the time period and the frequency of compounding. Compounding can be annual, quarterly or monthly.
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The calculator uses a formula that calculates the compound interest accrued over the period and computes the future value of the investment.
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The calculator also helps you to understand growth projections over specified periods of time, enabling you to compare different scenarios.
How Can a Compound Interest Calculator Help You?
As an investor, you can use the UTI MF compound interest calculator and avail of its multiple benefits.
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It provides an representation of the future value of potential returns that can be generated by investing in an instrument working on the principle of compounding.
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It can help you illustrate your progress towards achieving your financial goals by enabling you to modify elements such as the total amount of money you invest and the duration of time over which you invest it.
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It saves you both time and effort by eliminating the need for guesswork or manual calculations that involve complex formulae.
How to Calculate Compound Interest with an Example
The following is the commonly used formula used to compute the amount of compound interest.
A = P (1+R/n) ^ (nt)
The following are the components for the same:
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Principal (P) – Initial amount of investment
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Interest Rate (R) – The rate at which the investment generates interest
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Compounding frequency (n) – Number of compounding periods in a year
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Time period (t) – Investment horizon, in years
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Amount (A) – Future value of total investment
Let’s apply this formula in a hypothetical example and understand the calculation better.
A person invests Rs. 1 lakh at an annual interest rate of 8% per annum, with the interest being compounded twice a year (that is, every six months) for 18 months. Under the assumption that the compounding frequency is semi-annual, the interest rate would be equal to 4% for each period of six months.
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The initial principal considered is Rs. 1 lakh.
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After six months, Rs. 1 lakh accrues 4% interest, worth Rs. 4,000, totalling Rs. 1.04 lakh*.
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After 1 year, 4% of Rs. 1.04 lakh equals Rs. 4,160, increasing the total amount to Rs. 1,08,160*.
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After 1 year and 6 months, 4% of Rs. 1,08,160 is ₹4,326, totalling Rs. 1,12,486*.
Therefore, compounding enables the investment to rise from Rs. 1 lakh to Rs. 1,12,486 in just 1.5 years, with the total interest amounting to Rs. 12,486*. This is due to the phenomenon of “interest on interest” at work on your investment.
Advantages of using a Compound Interest Calculator
The following are certain benefits of using the UTI MF compound interest calculator.
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It delivers a representation of how your investment would grow over the considered time period, negating any possibility of error in manual calculations.
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It provides a user-friendly interface that lets you calculate the corpus as many times as you want, using different inputs, saving time and effort.
Difference Between Simple Interest and Compound Interest Calculation
Simple interest is calculated only on the principal amount of the investment. However, compound interest considers both the principal amount along with the accrued interest for interest calculation.
Let’s consider certain parameters to understand the difference better.
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Simple interest follows a linear path across the investment period whereas compound interest follows an exponential curve during the same time.
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Simple interest generated every year stays the same irrespective of the tenure of the investment. However, compound interest generated increases every year due to the reinvestment of the accrued interest until the last compounding period, resulting in potentially significant increase in the corpus.
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In the case of compound interest, the accrued interest is added on to the principal amount for interest calculation. However, for simple interest, the principal amount remains constant, resulting in equal interest amounts.
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Frequently asked questions
Have questions? We are happy to help.
It’s easiest to just calculate compound interest online using our compound interest calculator. However, if you want to manually calculate compound interest, you can either use the formula shared above A = [{P(1 + r/n)}^nt] OR you can use the Future Value function in Excel to calculate compound interest.
SIPs do not provide any interest like bank deposits. However, when you invest in any mutual fund scheme through growth option, the returns you earn are reinvested in the scheme. Thus, you can earn returns on the reinvested value too, thereby growing your wealth with the power of compounding.
Power of compounding refers to the phenomenon of your interest earning interest (along with the principal) and helping your wealth grow exponentially. For e.g. if you invest 1000 in a bank offering 10% interest rate (annual), your amount becomes 1100 at the end of the first year, 1210 at the end of the second year and so on.
Compound interest investments are those which allow you to earn further interest/returns on your accumulated profits; for e.g., fixed deposits, mutual fund (growth option), public provident fund, unit linked insurance plans, etc.
While simple interest considers only the principal amount for interest calculation, compound interest calculates interest on principal and accumulated interest.
Compound interest is a valuable mechanism for the accumulation of long-term wealth, as it has the capacity to produce exponential returns. It also encourages investors to stay invested for longer periods of time, building discipline and perseverance. Compounding can also help to prevent the erosion of value of the investment over time, thus potentially acting as an inflation hedge.
The above calculation is for illustration purpose only and not an indication of the performance of any schemes. Calculations are based on assumed rate of return and actual return may vary. Performance may or may not be sustained in future. Please get in touch with your professional advisor for a detailed suggestion. The calculations are not based on any judgments of the future return of the debt and equity markets / sectors or of any individual security and should not be construed as promise on minimum returns and/or safeguard of capital. While utmost care has been exercised while preparing the calculator, UTI MF does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of the use or in respect of anything done in reliance of the calculator. The examples do not purport to represent the performance of any security or investments. In view of individual nature of tax consequences, each investor is advised to consult his/ her own professional tax/ financial advisor before taking any investment decision. SIP is a feature offered for disciplined investment of a certain amount on a pre-decided date in a specific mutual fund scheme, regularly over a period of time.
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