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Compound Interest Calculator: Benefits, Uses, How it Works?

By PolicyBazaar
  | Published: 02 December 2020 | Last Updated On: 23 December 2020

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Compound interest adds the accumulated interest amount back to the principal amount. With this type of interest, the sum of interest earned keeps on increasing with the rise in the sum of investment be it monthly, quarterly, or annually. To put it simply, you can earn interest on top of interest.

A compound interest calculator aids you in calculating the estimated valuation of your investments after a specified number of investments made monthly, on the basis of the interest earned on the sum invested. You can also do this with a single investment or the initial investment.

How does compounding work?

Compounding refers to reinvesting the returns at the exact same rate of interest in order to cultivate the principal sum of money every year. This way even the interest from the money you have invested, also earns interest. This phenomenon is known as compound interest. This type of interest keeps on increasing geometrically rather than arithmetically. By reinvesting the earnings at a compound rate of interest helps in increasing the principal sum of money continually year after year.

Compound interest proves to be a powerful tool in helping investors plan their future financial goals. It is an extremely useful technique for all investors. Typically, the longer the horizon of investment, the greater are the returns earned. Starting early gives the investors the benefit of a larger compounding effect, helping them build their wealth over time. Compounding offers endless possibilities as it not only inflates the earnings of the investor but also offers the opportunity to invest further.

Compound interest is calculated in a number of ways. They are:

  • Daily compounding calculations
  • Monthly compounding calculations
  • Quarterly compounding calculations
  • Semi-annual compounding calculations
  • Annual compounding calculations

The method of compounding is applied to the money deposited in bank accounts, loans as well as investments. The frequency of compounding merely means the number of times the interest is computed in one year. The more is this frequency of compounding; the more is the sum of compound interest. This frequency of compounding will depend on the instruments. For example, a savings bank account has to be compounded on a daily basis whereas a credit card loan, personal loans, home loan has to be compounded monthly. This frequency of compounding differs on the basis of the scheme put forth by the financial institution or by your bank.

In order to get the most benefits offered by compound interest, one should ideally invest a small sum of money regularly over a long duration of time. All long interval financial goals become easier and plausible with the fascinating power of compounding. To do the calculations, use a compound interest calculator and see the magic unfold within seconds. All investors should make use of this tool while planning their finances. One need not be well-versed with the subject of finances to understand the basics of compounding. Let us take an example to see how it works:

If AED 100 were to be invested at a rate of 6 percent per annum, compounded annually. AED 100 will be our principal and it will earn an interest of AED 6 (6 percent of 100) at the end of 1 year. Rather than withdrawing this amount, if one was to reinvest it then the new principal is AED 106 and when compounded annually at 6 percent per annum, it will earn an interest of AED 6.36. This amount is AED 0.36 more than the initial interest earned. This sum looks meagre but when calculated over a longer period of time and for a greater principal amount, it will make a significant difference. Therefore, it is said that to reap the benefits of compounding all you need is patience! 

How does a compound interest calculator work?

Compounding helps one earn additional earnings from their investments. It is essentially interest earned on interest. It magnifies your returns manifold times over a long period of time. A compound interest calculator makes use of this principle of compounding to let you ascertain the value of your investments. 

This calculator helps in calculating the worth of a specific investment after a duration of “n” years at a given rate of interest. It relies on the principle of compound interest to make these calculations. The formula used by the calculator is as follows:

P {[(1 + I) ^ n] - 1}

Where P= Principal

I= Annual interest

n= number of years or periods

A compound interest calculator is an essential tool in understanding the amount an investor can earn by investing a fixed amount for a defined period of time at an interest rate that is pre-defined. The investors get an idea of their potential profits from making an investment. It is also a smart way to estimate how much your savings can grow by making that investment.

The compound interest calculator has the below-mentioned components-

  • Initial Amount or the Principal Amount of investment
  • The Rate of Return that one can expect to earn from making the investment
  • The time period in years for investing the amount

How to use a compound interest calculator?

The best part about this calculator is that it is easy to use. All one needs to enter is:

  • The principal amount
  • The rate of return
  • The period of investment

Filling these fields up will let the investor ascertain the returns they will earn. Once filled, the compound interest calculator will provide the following information within seconds:

  • The total investment amount
  • The amount at maturity either in graphical form or numerical or both
  • The returns earned

To put it simply, the compound interest calculator displays the amount at maturity from the lumpsum investment made after a fixed duration, calculated at a specified rate of return. Let us understand this using an example:

If an investor makes an investment of AED 100,000 at an interest rate of 12 percent for a period of 10 years, compounded annually, he/she will have to make the following entries in the calculator:

  • The principal amount: AED 100,000
  • The rate of return: 12 %
  • The period of investment: 10 years

The below-mentioned figures will be churned out by the compound interest calculator, perhaps even with a graphical representation of the data-

  • The total investment amount: AED 100,000
  • The amount at maturity: AED 310,585
  • The returns earned: AED 210,585

The calculator also helps the investors compare the funds that earn them the most returns or at least the expected returns in a fixed period of time. Usually, these calculators suggest several investment portfolios on the basis of the investor’s needs.

Benefits of a compound interest calculator:

These calculators prove to be extremely handy by predicting your future, or at least the future of your investments. Here are some of the benefits of using such a calculator:

Essay to Use: These calculators are easy to use as the process is extremely user friendly. The investors only have to enter the required information in the correct field or choose the options that best meet their requirements in order to get an estimate of returns from their investments in percentage. Some of them even offer a graphical representation of the returns earned, making it even more understandable and easy to interpret.

Saves Time: Remember solving compound interest problems in school? They were always quite complicated and time-consuming. The process of computing the compound interest applicable to the investments as well as ascertaining the results manually can be a tiring process. The compound interest calculator gets you accurate results that too within a few seconds, thus saving time.

It’s Free: These calculators are available across several online portals and that too for free. An investor can use these from the comfort of their home as many times as they like. It is thus a cost-effective way to plan your finances as well as your future.

Allows Comparisons: A calculator like this helps investors in entering varying information to get an idea of the multiple different scenarios of investing. The investors can tweak the rate of return or the investment amount, for example, to get different results. This helps them in comparing the distinct results and choosing the right plan that will be best suited for them.

Plan the Future: A compound interest calculator aids in future financial planning. Using the calculator to figure out how what amount will an investment reap, before making any investments. This allows them to compare all the possible plans and eventually choose the best as well as the most profitable alternative for them.

Things to remember to make the most of compound interest:

  • Start investments as early as possible to build your wealth and achieve your long-term financial goals.
  • Practice patience as compound interest shows its magic over longer durations.
  • Be careful with your spendings. Start with a small amount if you don’t have a lot and build it over time.
  • Choose higher compound interest rates annually to earn higher returns.
  • Have a higher frequency of investing for greater wealth accumulation.

In a Nutshell

Using a compound interest calculator can offer you the ease of making informed decisions when it comes to your investments. It will prevent you from making any bad decisions, encouraging more investment on your part to secure the future of you and your family. As a beginner, one needs all the help one can get to make wise investment choices and this calculator will certainly prove to be your best friend!