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The compound interest formula is of basic importance in finance and economics. Before learning about its formula, let us learn about what exactly compound interest is. It simply means that you will get your initial investment plus a certain amount of return on it every year. This means that instead of being paid just once, you will be paid multiple times in one go with each payment including your principal as well as a certain proportion of profit.
The formula for compound interest is:
A = P (1 + r/n)nt,
A = Amount of investment at end of the period,
P = Principal amount invested,
r = Rate of interest per period,
n = Number of periods
t = Time in years.
In simple words, the compound interest formula states that a certain amount invested today will grow exponentially with time. The higher your rate of return, the more your money is going to increase.
Example 1: Let us take an example to understand how it works better. Suppose you have saved $100,000 by putting away $5,000 every year over 20 years from now till retirement age.
Example 2: Now if you invest all these savings in a bank that pays you a 5% annual interest rate compounded annually on your principal amount then how much would your savings be worth after 20 years? Here is a calculation of the compound interest formula with which we can find out that your investment will grow to around $164,295 at maturity.
Here is another important aspect of the compound interest formula that you need to remember the time value of money. It states that money today is more valuable than money tomorrow because people generally prefer consumption sooner rather than later.
The compound interest formula calculates how much interest you would earn on an investment. To illustrate compound interest, let’s say you have 10,000 rs invested at 5% and it compounds annually for the term of 20 years.
- Initial balance: 10,000 ₹
- Interest rate: 5%
- Term: 20 yrs 0 mos
- Compounding frequency: yearly (1/Yr)
After 20 Years you will have 26,533 rs which means the total compound interest after 20 years will be 16,533 you.
The great thing about compound interest is that it’s a passive way to make money; that is, you don’t have to put in any additional effort to earn your compound interest.
- The more you save, and the longer you invest, compound interest will have a greater impact on your wealth.
- The earlier you start investing, the compound interest will have a greater impact on your wealth.
- The higher your rate of return, the compound interest will have a greater impact on your wealth.
- The lower your tax rate, compound interest will have a greater impact on your wealth.
- If you are saving in an account that compounds daily, you’ll earn more money over time than if you’re saving in an account that compounds annually.
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