Did you know that Albert Einstein during one of his speeches said that compound interest is the eighth wonder of the world? Let us learn about it. We will learn the formula to calculate compound interest and also see its real-life applications. We can define compound interest as the interest that accrues when earnings for a specified period of time is added to the principal amount thus increasing the principal base on which subsequent interest is calculated. Compound interest formula can be a bit tricky for many students. The concepts of this chapter if learnt online can be grasped very easily. Maths online classes like cuemath for topics like compound interest helps students visualize problems and the solutions attached to it in a fun way
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Formula for Compound Interest
Compound interest in a layman’s language can be called ‘interest on interest’. We can calculate compound interest with the help of the formula given below:
CI = P ( 1 + r/n )^nt – P
In the above mathematical expression,
- CI means compound interest
- P means the principal amount
- r means the rate of interest in decimals
- n means the number of times the interest is compounded on annual basis
- and t is the overall tenure.
Difference Between Simple Interest and Compound Interest
Simple interest can be calculated with the help of the given formula:
SI = (P × R × T) / 100
P is the principal
R is the rate of interest
And T is the time period.
The main difference between simple interest and compound interest is that in simple interest, the principal remains constant, whereas in the case of compound interest, principal goes on changing at the end of a specified period.
Applications of Compound Interest
There are innumerable life changing applications of compound interest. Albert Einstein had once said that one who understands compound interest, earns it, while the one who doesn’t pays it. You can understand the following applications of compound interest through maths classes online. Let us now discuss in detail the applications of compound interest.
Helps in Making Investment Decisions
Compound interest helps you in making investment decisions. It is very important for all of us to invest in assets that can generate cash flows in the coming future. But how will you determine that those investments will be profitable for you? For making investment decisions, we compare the present value of cash outflow and the present value of cash inflows. If the present value of cash inflows is greater than the present value of cash outflows, the decision should be in the favour of investment.
Helps to Grow Wealth Faster
Compound interest makes an amount of money grow faster than simple interest because you earn returns on the amount that you invest as well as on the returns that you have generated by investing. Compounding’s magic is important for anyone looking to create wealth. It also helps us to mitigate factors like inflation, rising cost of inflation and so on.
Helps in Calculating Compounded Annual Growth Rate (CAGR)
Compounded Annual Growth Rate or CAGR is a term used specially in businesses or investing for the smoothed annualized gain of an investment over a given time period. It is used particularly in growth industries or to compare growth rates of two or more companies. CAGR dampens the effect of volatility of periodic returns that can render arithmetic means irrelevant for companies. It is often used to show the growth over a period of time of some element of the business. Various examples of which can be revenue, units delivered, and so on. It also helps us in comparing the historical returns of stocks with bonds or with a savings account.