Compound Interest

Compound interest is an interest accumulated on the principal and interest together over a given time period. The interest accumulated on a principal over a period of time is also accounted under the principal. Further, the interest calculation for the next time period is on the accumulated principal value. Compound interest is the new method of calculation of interest used for all financial and business transactions across the world. The power of compounding can easily be understood, when we observe the compound interest values accumulated across successive time periods.

A sum of money of $100 invested over a period of time for a 10% rate would give a simple interest of $10, $10, $10... over successive time periods of 1 year, but would give a compound interest of  $10, $11, $12.1, $13.31... Let us understand more about this, and the calculations of compound interest in the below content.

The compound interest is calculated, after calculating the total amount over a period of time, based on the rate of interest, and the initial principal. For an initial principal of P, rate of interest per annum of r, time period t in years, frequency of the number of times the interest is compounded annually n, the formula for calculation of amount is as follows. 

The above formula represents the total amount at the end of the time period and includes the compounded interest and the principal. Further, we can calculate the compound interest by subtracting the principal from this amount. The formula for calculating the compound interest is as follows 

In the above expression,

• P is the principal amount
• r is the rate of interest
• n is frequency or no. of  times the interest is compounded annually
• t is the overall tenure.

It is to be noted that the above-given formula is the general formula when the principal is compounded n number of times in a year. If the given principal is compounded annually, the amount after the time period is given as:

A = P(1 + r/100)^t, and C.I. would be: P(1 + r/100)^t - P .

The formula for compound interest can be derived from the formula for simple interest. The formula for simple interest is the product of the principal, time period, and rate of interest (SI = ptr/100). Before looking into to derivation of the formula for compound interest, let us understand the basic difference between simple interest, compound interest computation. The principal remains constant over a period of time, for simple internet computation, but for compound interest computation the interest is added to the principal, for compound interest computation.

Derivation: 

Let the principal is P and the rate of interest be r. At the end of the first compounding period, the simple interest on the principal is P × r/100. And hence, the amount is P + P × r/100 = P(1 + r/100). The amount is taken as the principal for the second computation period.  

At the end of the second compounding period, the simple interest on the principal is: P(1 + r/100) × r/100, and hence the amount is: P(1 + r/100) × r/100 + P(1 + r/100) × r/100 = P(1 + r/100)².

Continuing in this manner for n compounding periods, the amount at the end of the n^th compounding period is A =  P(1 + r/100)ⁿ. 

From the above formulas and computations, you can observe that the compound interest is the same as simple interest for the first interval. But, over a period of time, there is a remarkable difference in returns. 

The simple interest value for each of the years is the same, as the principal on which it is calculated is constant. But the compound interest is varying and increasing across the years. Because the principal on which the compound interest is calculated is increasing. The principal for a particular year is equal to the sum of the initial principal value, and the accumulated interest of the past years. 

For example, a sum of $10,000 is deposited at a rate of 10%. The below table explains the difference between simple interest and compound interest computation on this principal:

Compound Interest Formula - Half Yearly

The interest in the case of compound interest varies based on the period of computation. If the time period for the calculation of interest is half-yearly, the interest is calculated every six months, and the amount is compounded twice a year. 

The formula to calculate the compound interest when the principal is compounded semi-annually or half-yearly is given as:

Here the compound interest is calculated for the half-yearly period, and hence the rate of interest r, is divided by 2 and the time period is doubled. The formula to calculate the amount when the principal is compounded semi-annually or half-yearly is given by: 

In the above expression,

• A is the amount at the end of the time period
• P is the initial principal value, r is the rate of interest per annum
• t is the time period
• C.I. is the compound interest.

Compound Interest Formula - Quarterly 

If the time period for the calculation of interest is quarterly, the interest is calculated for every three months, and the amount is compounded 4 times a year. The formula to calculate the compound interest when the principal is compounded quarterly is given as:

Here the compound interest is calculated for the quarterly time period, and hence the rate of interest r, is divided by 4 and the time period is quadrupled. The formula to calculate the amount when the principal is compounded quarterly is given by: 

In the above expression,

• A is the amount at the end of the time period
• P is the initial principal value, r is the rate of interest per annum
• t is the time period
• C.I. is the compound interest.

Important Notes

1. Compound interest depends on the amount accumulated at the end of the previous tenure but not on the original principal. 
2. Banks, insurance companies, etc. generally levy compound interest.
3. If the interest is compounded quarterly, the formula of amount is given by:\begin{equation}A=P\left(1+\frac{r / 4}{100}\right)^{4 n}\end{equation} 
4. While calculating the compound interest, the rate of interest, and each time period must be of the same duration.

Tips & Tricks

• The rule of 72: It is a quick method to know how long it will take for your money to double. Doubling Time = 72/Interest Rate 
  Using the rule of 72, we can find the number of years to double your money by simply dividing 72 by the rate of interest. For example, at an 8% compounded interest rate your money will double in 72 ÷ 8 = 9
• The time duration over which an interest rate is applicable is referred to in many different terms. Sometimes it is called “per annum” or “annual” or “per year”. All of these mean you’ll get the given rate of interest over a period of 1 year. Semi-annual is 6 months. While quarterly is 3 months duration.

How to Calculate Compound Interest?

The formula used to calculate compound interest is CI = P( 1 + r/100)ⁿ - P.  Here in this formula the amount is calculated and then the principal is subtracted from it, to obtain the compound interest value.

What Is the Difference Between Simple and Compound Interest?

Simple interest is the interest paid only on the principal, whereas, compound interest is the interest paid on both principal and interest compounded at regular intervals.

How to Calculate Amount Using Compound Interest?

There is a direct formula for the calculation of compound interest. A = P(1 + r/100)ⁿ. Here we need to define the rate of interest and the time interval at which the compound interest is calculated. 

Is Interest Compounded Daily Better than Monthly?

The interest compounded daily has 365 compounding cycles a year. It will generate more money compared to interest compounded monthly, which has only 12 compounding cycles per year.

What Are the Main Disadvantages of Compound Interest?

If we miss a payment by a day also, towards the end of tenure it may incur a huge loss. The interest calculation is for the next cycle and for a higher value. Compound interest is actually designed to help the lenders but not the borrowers.

How Does Compound Interest Depend on Time Period?

The compound interest depends on the time interval of calculation of interest. The time interval for the calculation of interest can be a day, a week, month, quarterly, half-yearly. For the shorter time period of calculation, the net accumulated compound interest is higher. 

How Much is Compound Interest Greater than Simple Interest?

The compound interest can be greater than the simple interest. The compound interest value varies and increases for successive time periods.  An initial principal of $100 invested over a period of time would give a simple interest of $10, $10, %10... over successive time periods of 1 year, but would give a compound interest of  $10, $11, $12.1, $13.31..... Thus the compound interest is greater than the simple interest. Only for the first year, or for the first cycle of calculation, the compound interest, and the simple interest values are equal.

Can Compound Interest be Greater than Principal?

The compound interest can be greater than the principal. The compound interest value varies and increases for successive time periods. An initial principal of $100 invested over a period of time would give a compound interest of  $10, $11, $12.1, $13.31....over successive time periods of 1 year each. Thus the compound interest increases over a period of time and can be greater than the initial principal value. 

How Do you Calculate Compound Interest for Half Year?

The formula for calculation of compound interest for half year is CI = p(1 + {r/2}/100)^2t.- p. Here in this formula 'A' is the final amount, 'p' is the principal, and 't' is the time in years. In the formula we can observe that the rate of interest is halved and the time is doubled, to account for the calculation of compound interest for half a year.

What Is the Information Required to Calculate Compound Interest?

The calculation of compound interest requires us to know the principal, rate of interest, and the time period. Also, we need to know the time interval for which the interest is to be calculated. 

What Are the Units of Compound Interest?

The units of compound interest are the unit of currency and are the same as the unit used for the principal value. If the principal is in dollars, or yen, the compound interest would also be in dollars or yen.