The 2 Ways of Investment Returns — Simple vs Compound Interest 

Aug 17, 2022

The 2 Ways of Investment Returns — Simple vs Compound Interest

Introduction

Whenever anyone seeks money from you, they make a promise to return it on time. A simple question arises here: where’s the guarantee that they’ll return your money?

Moreover, why should you lend money to someone you’ve never known? The answer is — interest

When someone takes a loan, they promise a annual percentage on the principal amount as interest. Banks, NBFCs, brokers, and everyone else you trust your money with pay interest. The interest percentage is the incentive for those who have money to give it to those in need.

Sometimes it’s also called the “return rate”. It is expressed as an annual percentage rate. Returns are the reason investors spend hours researching assets to buy and sell.

Two types of interest calculations are applied to money: simple and compound.

Simple Interest

Every investment has a maturity period or tenure. It’s the time during which the investment remains active and generates returns for the investor.

A simple interest rate is the rate of return you calculate yearly on the principal. You can calculate simple interest with the formula: (principal x interest rate x tenure)/100. This gives the total return an investor gains on the principal over the investment period.

Compound Interest

In the compound interest method, the annual return amount is added back to the principal. You calculate the next year’s interest on this new principal. It again is added back to the principal. This process goes on like this until the end of the tenure.

So naturally, the final return is a lot higher than that obtained by the simple interest method. You can calculate compound interest with the formula: 

A = P x [1 + r/n] ^ nT 

Where, n is the number of times the interest is compounded every year, and T is the tenure in years.

A is the maturity amount.

P is the principal.

You represent the rate of interest in the decimal form by ‘r’. 

Now comes the million-dollar question: why choose compound interest over simple interest? Let us take a simple example. Suppose, you invest INR 1000 each in simple interest and compound interest schemes. Both schemes offer annual interest of say, 5%. 

Now, in the simple interest scheme, at the end of the first year, you will get a return of INR 50. However, for the second-year interest calculation, the interest accrues on the base amount of INR 1000 again. So, you will consistently get INR 50 as your return every year.

However, the power of compound interest will give you more profits. At the end of the first year, the interest of INR 50 that you earn will take your total investment figure to INR 1050. The second year’s interest accrues on this figure, giving you a return of INR 52.5. With each year, your corpus will race ahead much faster with compound interest than simple interest.

Investment instruments using simple interest

The following are some simple interest-based instruments:

  • Bank fixed deposits 

A bank fixed deposit is one of the most well-known forms of fixed investment instrument. Here the bank gives you an annual return on your principal using simple interest. You can choose whether you want the interest to be half-yearly, quarterly, or monthly. 

  • Government schemes

The senior citizen saving scheme and the PMVVY (Pradhan Mantri Vaya Vandana Yojana) are fixed return schemes for senior citizens. They pay interest above 7% on a simple interest basis.

  • RBI floating rate bond

While the return on the bond accrues in line with the simple interest formula, the rate varies from time to time. This is not bad news as there’s a chance that you can always earn a higher interest.

  • Corporate bonds

Reputable companies offer corporate bonds to finance their business expansion or related costs. This bond works on the principle of simple interest. Generally, you can consider them as a medium or long-term investment option. They have higher yields than average. It is advisable to go for AA+ rated corporate bonds. 

Investment instruments that use compound interest

Instruments that use compounding are best to grow your wealth. Take a look at some of the common compound interest instruments.

  • Recurring deposits

Recurring deposits (RDs) are the best option to save for a mid-term goal. You can deposit every month to earn a compounded return on your investment and a larger maturity amount at the end of the tenure. Along with bank RDs, post office RDs are also a good option.

  • Gold bonds

The RBI issues the sovereign gold bond. It pays compound interest and pays you a lump sum amount at the end of its term. 

  •      Mutual funds

Mutual funds offer the best example to demonstrate the compounding effect. You can choose from a variety of equity mutual funds and debt mutual funds to let your money grow through compounding. By investing your money for a time interval, you get more returns.

  • Bond funds

These are a type of mutual funds that invest in high-yield bonds and securities. They don’t give a periodic payout but compound the returns earned. At maturity, you get a good return.

  •      Public Provident Fund

Public Provident Funds or PPFs allow you to invest money for 15 years. You can invest as much or as little as you can at frequent intervals. It is a safe investment option that offers compound interest.

P2P Lending – An Emerging Investment Opportunity

India’s growing economy has been seeing new investment options emerge at a brisk pace. It’s a great time to invest. Peer-to-peer lending is one such emerging investment opportunity. LenDenClub divides your money into a large number of small chunks and uses it to serve different loan requests. The repayment interest, in turn, contributes to your profit. By spreading your risk, the platform minimizes it. As an investor, you can invest your money in P2P for great returns over the years. LenDenClub uses artificial intelligence to invest your money efficiently. Its AI-powered mechanism re-invests your money in a hassle-free manner and gives you the benefit of compound interest. LenDenClub’s Fixed-Maturity Peer-to-Peer or FMPP investment plan offers an annual return of up to 1012%*. You can invest for one to five years, depending on your financial objectives.       

Tips to compound one’s interest earnings

  1. Always look to reinvest. If you have earned a good dividend on some stocks, don’t spend it. Buy a couple of other shares.
  2. Take advantage of the insurance schemes. Along with LIC, you must explore other insurance plans.
  3. Utilize RDs. Banks, post offices, and many other NBFCs are offering RD schemes. Use them to compound your earnings. Go a step ahead and give each of your RD accounts a purpose — Greece vacation, car fund, house/flat money, and emergency.
  4. Use interest to buy mutual funds. This way, you protect your capital while also growing your wealth.

Final words

By understanding simple and compound interest you can make the right decisions when picking instruments. Today’s market has many options along with many risks. You need to move carefully and understand every element of an asset. 

Investing in secure and trustworthy platforms such as LenDenClub can help you scale to high profitability. Irrespective of whether you are a beginner or an investment pro, you can generate great returns from your P2P investment at LenDenClub. So, what is stopping you? Invest in LenDenClub today!

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