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Monday, October 2, 2023

Interest rate is a common concern for investors as well as borrowers. While the former looks for a higher rate of interest to increase his/her earnings, the latter focuses on acquiring a lower rate to keep the total debt in check.

Compound interest is a point of interest for investors, directly influencing their income generation through investments. Hence, individuals planning to invest should understand the advantages of this interest computing mechanism to reap its benefits.

Five advantages of compound interest

Here are five notable advantages of using compound interest for calculation –

1.Accelerated growth

The idea of compound interest has a simple yet appropriate explanation, i.e. interest on interest. It means the investment income is added to accumulate further earnings. This concept, however, is not applicable for simple interest, which computes return on the principal amount, and does not factor in the previously generated income.

Therefore, this interest calculation process possesses better growth potential than a simple interest method over a similar period. However, this is unsuitable for borrowing options like personal loans and likes.

2. Better potential in the long run

Compound interest generates higher returns; the previous point establishes this statement. The subsequent interest generated on the initial investment gets compounded every time, resulting in higher returns.

Now, over a longer period, this holds the possibility to generate remarkably high income on any investment. Hence, individuals will have the incentive to let their money sit and grow.

3. Compounding frequency plays a key role

Compounding frequency directly impacts the income generated through this method of interest calculation. A higher frequency can increase the return several times and vice versa. Typically, the frequency can be yearly, half-yearly, and quarterly for compound interest.

Here is an example to illustrate it further –

For instance, Rs. 6.5 lakh will generate Rs. 10.35 lakh when compounded annually for 10 years at 10%. Whereas, when compounded every six months, the same amount will produce a total interest of Rs. 10.74 lakhs over the same period.

4. Early investment leads to higher income

As stated above, the investment horizon plays a vital role in determining the returns earned through this interest calculation method. Resultantly, it is ideal to prioritise investment from an early age. This will enable individuals to keep their money invested for a more extended period and generate a higher income.

5. Interest rate is the catalyst

While being wary of the mechanisms to better income generation through investment, individuals should also take note of the available interest rate. Since it will ultimately decide the total earnings, and it is true for both compound and simple interest.

Being aware of the advantages of compound interest can help individuals plan their investments accordingly. Simultaneously, they should also learn that the compound interest rate formula does not apply to any credit instrument.

Instead, financial products like personal loans and likes use the reducing balance method. Thus, prospective borrowers should consider the factors that affect the personal loan interest rate and plan accordingly.

How is the interest rate calculated on credit instruments?

Even though advantageous for investors, compounding can be an enemy when it comes to borrowing. On the other hand, the reducing balance method applicable on loans is a better option.

Under this method, financiers review the interest amount payable every month based on the then outstanding balance. 

Therefore, mathematically, it can be represented as:

  • The interest component of each EMI = Outstanding amount x Applicable interest rate

Therefore, the total debt amount shares a proportionate relationship with the total interest payment.

For example, a debtor who has borrowed Rs. 6 lakh at 12% reducing interest rate for four years will have a total interest outstanding of Rs. 1,58,424. After he/she pays the first EMI of Rs. 15,800, the next month’s interest will be computed minus the repaid amount on the starting outstanding balance. Borrowers can lower their total outstanding amount by planning their personal loan EMI repayment better.

Simultaneously, borrowers need to factor in other reasons to understand how they can get a better interest rate on a personal loan or any other financial product. This can include meeting eligibility parameters and several other factors.

Along with lowering the applicable interest rate, potential borrowers can also opt for lenders simplifying the loan application process. For instance, Bajaj Finserv provides pre-approved offers that streamline loan applications and save time. These offers are applicable on financial products like business loans, personal loans, credit cards, etc. Individuals can now check their pre-approved offers by submitting their essential contact details.

To sum up, compound interest can have a significant effect on investment as well as debt. However, since it is not applicable on loans, they can be one of the better ways to consolidate debts rather than liquidating investments.

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