Confused how compound interest works? These everyday examples can help
What's the story
Compound interest is one of those financial concepts that can make a world of difference to your savings and investments over time.
Unlike simple interest, which is calculated solely on the principal amount, compound interest accrues on both the original principal and the interest earned in previous periods.
Here we explain how compound interest works through relatable everyday examples, demystifying this powerful financial tool.
Example #1
The power of savings accounts
Let's say you open a savings account and deposit ₹1,000 with 5% annual interest.
With compound interest, not just your ₹1,000 earns 5% every year but any interest earned also earns more interest in the coming years.
As time passes, this compounding can grow your savings significantly without any further deposits.
Example #2
Investing in mutual funds
Investing in mutual funds also involves compound interest.
Let's say you invest ₹10,000 in a mutual fund that has an average annual return of 8%. Each year, your investment grows by 8% (this growth compounds every year).
Over a few years or decades, even a small initial investment would have grown significantly, thanks to compounding returns.
Example #3
Education loans and interest accumulation
Compound interest isn't limited to savings; it also applies to loans such as education loans.
If you borrow ₹50,000 for education at an annual rate of 6%, the total amount owed keeps increasing every year as the unpaid balance accrues more interest.
Understanding how compound interest affects loan repayment can help you plan better for your financial future.
Example #4
Credit card debt considerations
Credit card debt also typically comes with high-interest rates compounded monthly/daily.
For example, if you have a ₹5,000 balance on your credit card with a 20% annual rate, not paying the balance off quickly means that the original debt and accrued interests will be compounded again.
This can result in your debt ballooning rapidly if you're not careful.
Example #5
Retirement planning benefits
When planning for retirement through accounts such as a retirement fund or pension plan that offers compound returns, it helps to start early.
Even small contributions made regularly over several years will be compounded significantly more than larger contributions made later on in life, as there are longer periods available for growth through compounded returns.