How Does Compounding works?
Which is better compounded daily or annually?
Compounding means earning interest on interest. It doesn’t matter when the investor receives the interest. However, the number of compounding periods do make a difference. The more the number of compounding periods, the higher will be the interest generated.
If the interest is compounded daily, then the number of compounding periods is 365. This means the interest will earn interest every single day of the year. However, in the case of annual compounding, then the compounding period is just one. Hence the interest earned can be less in this case.
Let’s understand this better with an example.
An investor, Ms Shika, invests INR 50,000 in a savings scheme that offers 10% interest. Her tenure of investment is three years. Let’s see the value of her investment at the end of 3 years in both cases.
On the first day in both cases, the interest for Ms Shika would be INR 13.69 (50000*10%/365). On the second day, in case of daily compounding, the interest would be calculated on INR 50,013.69. This is because the interest will earn interest in daily compounding. However, in the case of annual compounding, the interest for a day throughout the year will be INR 13.69. This is because the interest calculation is on INR 50,000 for the entire year. At the end of the year, the interest calculation is on INR 55,000 (50000+13.69*365).
At the end of 3 years, in case of daily compounding, the maturity value of the investment would be INR 67,490.16726. And in case of annual compounding, the maturity value would be INR 66,550.
The difference between the maturity value of daily compounding and annual compounding is INR 940.16. Hence, daily compounding is better than annual compounding due to higher number of compounding periods.
Is simple or compound interest better?
Simple interest is the interest one earns on the principal. One can calculate it by simply multiplying the principal amount with the interest rate and tenure. Compound interest formula is based on the principal and interest that is accumulated in every compounding period. Simple interest formula is easier to understand than compound interest formula. However, when it comes to investing, an investor will benefit more from compound interest than simple interest.
Let’s understand it better with an example. Mr Akhil is an investor who invests a sum of INR 10,000 for a period of 5 years. The interest rate offered to him is 10%.
In case of simple interest, Mr Akhil will earn an interest of INR 5,000. The total value of his investment at the end of 5 years is INR 15,000. Using the compound interest formula, the interest amount will be INR 6,105.1. The total value of his investment at the end of 5 years is INR 16,105.
Hence one can earn higher interest in case of compound interest. Therefore compound interest is better than the simple interest in case of investing. However, when one is borrowing, simple interest is better as the interest payment will be lesser.
What is compounded annually?
Compounded annually implies the interest is compounded at the end of the year. In other words, the interest will earn interest at the end of the year. During the rest of the days, the interest will be calculated on the principal amount.
Let’s understand this better with an example. An investor wants to invest INR 20,000 in a savings scheme that offers a return of 12% for a tenure of 3 years. The compounding of interest is done annually.
The investment will start earning interest right from the first day of investment. So on day 1, the interest would be INR 6.57. For the next 364 days, the interest calculation on the principal amount and will be INR 6.57. At the end of the year, the value of the investment would be 22,400 (INR 20,000+(6.57*365)).
From the second year, the interest calculation is on INR 22,400 instead of INR 20,000. Hence the interest will earn interest only at the end of the year. By the end of the third year, the value of the investment would be INR 28,098.56
Is credit card interest compounded daily?
Yes, the credit card interest is compounded daily. Credit card interest calculation is on daily based on the average daily balance during the statement period. However, the interest charges are waived if the balance is paid off before the due date.
Credit card interest calculation is on the average daily balance with daily periodic rate and the number of the days in the billing cycle.
The interest calculation is irrelevant if one is paying off their credit card dues on time. The interest calculation is done during the grace period. Grace period is the time between the statement closing date and the due date. To avoid paying interest, one can pay off their credit card dues on time.
Who benefits from compound interest?
A person who lends or invests the money will benefit from compound interest. Compound interest will help in increasing the pace of money growth. This is because the principal and the accumulated interest earn interest. This creates a snowball effect, and both the investment and interest grow together.
A lender would benefit from compound interest, while a borrower will have to shell out more interest. However, in an investing scenario, an investor would benefit from compounding. The more the number of compounding periods, the higher will be the accumulation of wealth.