What is compound interest?
If you have experienced investing in different markets, you are familiar with the concept of profit and return. You also know that every market has a specific rule for profitability. If you have deposited your capital in a bank, you will find that a certain amount is added to your initial capital each year.
If you withdraw the earned profit from your account, you will still receive interest on your principal. Also, if you buy gold or foreign currency, you will only benefit from the difference between the purchase price and their daily price. But if you are active in the stock market, profits will not only be added to your capital. This means that if you have invested an amount first and a percentage of profit is on it, in the following days the amount of profit will increase exponentially and with the same percentage of profit, the profit earned in one day will be more than the other day. Was. The reason for this is that returns on the stock market and the stock market are calculated as compound interest. The concept of compound interest is described below.
Types of profits
As we explained in previous articles, profit or return is the reward we get on our investment over a period of time. In other words, interest is the amount of money that the borrower pays to the lender as the cost of the loan. Interest is also the return on investment in various financial assets. Due to the existence of various financial instruments in the capital market, there are also types of interest. In terms of interest calculation, there are two types of interest and simple interest in the market. If profit is only a return on the principle of capital, it is called simple profit or interest. In the simple profit method, the interest received is not invested and only the interest received from the same initial capital is paid. But when the return is calculated on the principle of capital plus past profits, the profit or interest is compound.
Compound Interest is compound or double interest. The compounding of interest means that interest is received on interest and the principle of money. So the profit will grow faster and more. In the long run, compound interest shows more and the return on the principal amount and profit will be much higher than the simple profit mode. In other words, compound interest exponentially increases the principal. Compound interest can also be considered interest on profit.
Calculate simple profit and compound profit
As we have said, in the Simple Interest method, it is assumed that the profits earned at different times are not added to the capital and the return on profits is not calculated. In the simple calculation of profit, only the principle of capital is used.
The simple interest equation is as follows:
Simple Interest = P × i × n
P: The principle of capital
i: Annual interest rate
n: Duration
But to calculate the compound interest, both the principal capital and its profit are given in the equation, and it is necessary to subtract the total amount of capital from the initial capital in a certain period of time.
The compound profit equation is as follows:
Compound Interest = [P (1 + i) ^ n] -P
Compound Interest = P [(1 + i) ^ n-1]
P: The principle of capital
i: Percentage of interest rates
n: Number of profit periods
According to this equation, the greater the number of profit periods, the higher the profit. Therefore, time plays a very key role in investing with compound interest. Investors need to consider long-term periods to maintain their capital to get higher returns than other methods.
Which method you use to return will make a significant difference in the interest you receive. It can be said that compound interest will increase capital and the investor will gain more wealth.
Example
To better understand the issue, in this section we calculate the return on an investment from the two methods of calculating simple profit and compound profit.
Suppose a person has deposited 1 billion Dollars in his bank deposit account. This person has invested his money for three years with an annual profit of 20%. The return earned per person over a three-year period is equal to:
1000000000 × 20% × 3 = Profit = 200000000
In the second year, the individual return will be equal to:
Profit = 1,200,000,000 [(1 + 20%) - 1] = 240,000,000
And the third year
Profit = 1,440,000,000 [(1 + 20%) - 1] = 288,000,000
In total, the total profit of the individual in these three years will be equal to:
Total profit = 200,000,000 + 240,000,000 + 288,000,000 = 728,000,000
Or the return calculation can be done as follows:
Profit = 100,000,000 [(1 + 20%) ^ 3-1] = 728,000,000
last word
Based on the above, we realized that how to calculate profits is very effective in the return on investment. Many rich people have increased their wealth by investing their capital in various sectors. They put the return on their capital into options that give them more profit than other options, or they reinvest their earnings to have more capital. Re-investing on the principle of capital and maintaining interest on the principle of money is the same as using compound interest.
