What is compound interest and what is its advantage?

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:46

Before every person who wants to open a bank account, the task is to choose the best bank and the most profitable type of account. And if everything is more or less clear with banks - you can navigate by numerous ratings and choose the branch that is not far from your place of residence, then choosing the type of account is much more difficult. Indeed, in addition to the amount of interest, it is also necessary to take into account the possibility of replenishing the deposit, early withdrawal, the method of calculating interest and other factors. In addition to the size of the percentage itself, its appearance is of great importance. Let us consider in detail how simple and compound interest differ from each other.

Simple interest. Calculation formula

With simple interest, everything is very clear, because it is studied at school. The only thing to remember is that the rate is always quoted for an annual period. The formula itself looks like this:

KS=NS + NSip=NS(1 + ip), where

HC - initial amount, KS - finalamount, i - the value of the interest rate. For a deposit for a period of 9 months and a rate of 10%, i=0, 19/12=0.075 or 7.5%, p – number of accrual periods.

Let's look at some examples:

1. The depositor places 50 thousand rubles on a term deposit, at 6% per annum for 4 months.

KS=50000(1+0, 064/12)=51000, 00 rubles

2. Term deposit 80 thousand rubles, at 12% per annum for 1.5 years. At the same time, interest is paid quarterly to the card (not added to the deposit).

KS=80000(1+0, 121, 5)=94400.00 r. (since the quarterly interest payment is not added to the deposit amount, this circumstance does not affect the final amount)

3. The depositor decided to put 50,000 rubles on a fixed-term deposit, at 8% per annum for 12 months. Replenishment of the deposit is allowed and for 91 days the account was replenished in the amount of 30,000 rubles.

In this case, you need to calculate the interest on two amounts. The first is 50,000 rubles. and 1 year, and the second 30,000 rubles and 9 months.

KS1=50000(1+0, 0812/12)=54000 rubles

KS2=30000(1+0, 089/12)=31800 rubles

KS=KS1+KS2=54000 + 31800=85800 rubles

Compound interest. Calculation formula

If the conditions for placing a deposit indicate that capitalization or reinvestment is possible, then this indicates that in this case a compound interest will be used, the calculation of which is performed according to the following formula:

KS=(1 + i) NS

The notation is the same as in the formula for simple interest.

It happens that interest is paid more than once a year. In this case compound interest is calculated a little differently:

KS=(1 + i/k)nkNS, where

k - frequency of savings per year.

Let's return to our example, in which the bank accepted a term deposit of 80 thousand rubles, at 12% per annum for 1.5 years. Assume that interest is also paid quarterly, but this time it will be added to the body of the deposit. That is, our deposit will be capitalized.

KS=(1+0, 12/4) 41, 5800000=95524, 18 p.

As you probably already noticed, the result was 1124.18 rubles more.

Compound interest advantage

Compound interest always brings more profit than simple interest, and this difference increases faster and faster over time. This mechanism is able to turn any start-up capital into a super-profitable machine, you just have to give it enough time. Albert Einstein once called compound interest the most powerful force in nature. Compared to other types of investments, this type of investment has significant advantages, especially when the investor chooses a long-term period. Compared to stocks, compound interest carries much less risk, while stable bonds offer lower returns. Of course, any bank can fail over time (anything happens), but by choosing a banking institution that participates in the state deposit insurance program, you can minimize this risk.

Soit can be argued that compound interest has much greater prospects than almost any financial instrument.