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Owning a small business, working in a corporate job, or being a student in any discipline, where ever you maybe you may have once a while encountered with the term” Compound interest”. Well, we’re in the 21st century, money has directly or indirectly some influence in your life. It’s not confined to commercial and financial platforms like banking, investment firms, so it’s better to get familiar with some common terms one of such is “compound interest” and if your mind boggles on every occasion see it, then this post is for you.
When someone without proper knowledge comes across the term “interest”, they often think of debt and loan. But they never wonder if interest can work in their favor, when earned money is saved and invested with a specific interest it would result in great gains.
The power of time and compounding is very great, if you are asked to choose between 1 million bucks or a single penny but double it each day for a month what would you choose?
If you choose 1 million bucks, you would be in a great loss. Doubling your single penny to 2 next day then 81.92 in the next two weeks hence finally results to 10 million bucks at the month-end, nearly 10 times what you were offered initially. Started wondering how did this happen, well let us start with the basics.

What is Compound Interest?

Compound interest is the addition of interest and the principal sum of a loan or deposit, as one can say “interest on interest”. It’s the calculated interest on the initial principal with the addition of the accumulated interest of the previous periods. You are not only getting interest on initial investment but also getting interest on top of interest! Your wealth is growing exponentially through compound interest. It’s like putting your money to work.
It can be contrasted with simple interest, where previously calculated interest is not added in the principal amount hence no compounding. The simple annual interest rate is also known as the nominal interest rate.

Compounding Frequency

You may haven’t heard about this term but it plays an essential role in calculating compound interest. Compounding frequency is the number of times per year (ratio of the accumulated sum in a year over initial investment) the accumulated interest is credited to the account, regularly. The frequency could be yearly, monthly, weekly, daily, continuously, or not at all. Monthly capitalization with interest expressed as an annual rate means the compounding frequency is 12, where the period is measured in months.
Compounding effect depends on:

  1. Nominal interest rate
  2. Frequency interest which is compounded

How to calculate compound interest

Total accumulated value including principal amount (P) and the compound interests over years (T) is given by the below formula.

Total value = P x (1+r / n)nT

r is a nominal annual interest rate
n is compounding frequency
T is time the interest is applied

Continuous compounding

If the number of compounding periods increases per year without a certain limit, its called continuous compounding. Continuous compounding can be defined as making the compounding period very small, it can be achieved by taking the limit with n tends to infinity.  The amount after t periods of continuous compounding can be expressed in terms of the initial amount Po as

P(t) = Po x ert

History peeks

Compound interest was once called the worst usury that was introduced in the banking and financial sector. It was denounced by laws of various countries and especially Roman law. For decades many author have defined compound interest in their book in slightly more improved ways than previous ones, but only a few made it out to be used by common laws.

  • Francesco Balducci in his book “Pratica Della Mercatura” provided an interesting table related to compound interest. It has an example in which a specific interest of rates 1% to 8%  was  given on quantity of 100 lire, for up to 100 years
  • Richard Witt’s book arithmetical questions was a breakthrough in the history of compound interest and brought a whole new idea.
  • The constant ‘e’ used in calculating compound interest was discovered by Jacob Bernoulli in 1683 when he was studying about compound interest.

Effects of Compound interest in life

Do you know what Albert Einstein said once “Compound interest can be the eighth wonder of the world? He who understands it earns it… he who doesn’t pay it.”
Compound interest can sound appealing, it makes a good effect when applied in your investment but can also bring some devastating effect to your debts, depends on how wisely you deal with it. It can work for you or against you. It teaches one patience, if you remain comfortable with it you will be rewarded for sure.
It’s a slow process that requires tolerance, calmness, and continuous submission of one’s wealth and could take years for the invested amount to multiply.

“Growth is never linear”.
One can never learn anything instantly, you have to spend some time on it, making mistakes, and then practicing on them is learning. The knowledge of compound interest can be gained by regularly investing and letting your wealth grow and work for you.

Pros and Cons of Compound Interest

  • Magic of compounding can bring great advantage when it is in your investments and becomes be a strong factor in the growth of one’s wealth.
  • The time required is more in comparison to other investments like mutual funds and share market, in terms of the growth of your investment but all you need is to sit back and let the compounding do its job.
  • Risk doesn’t come while compounding your money when it is landed into safe sectors like well-known banks and investment firms, which have a strong defined policy for the interest rates and the compounding periods. Unlike an investment in stocks could crash you to bottom with a little mistake.
  • Returns could be lesser when compared to other sectors like real-estate and share markets, but only if you have good knowledge and experience in them, they could bring massive increase into your wealth and could even make you bankrupt if not financed wisely.

Concluding thoughts

Don’t just try the Magic of Compounding in wealth, rather try to employ it in every aspect of your lives. It is like momentum which gains its energy slowly and then reaches its max, just like an avalanche which is started from a small disturbance then results in a big snowstorm.
Regular practices and disciplines can bring massive results in one’s hustle to achieve his ambition. Don’t just try something once try and try it and until you become master at it, then apply it to triumph your goal.