Pros and Cons of Compound Interest

 

What are the pros of compound interest?

Now that you know what compound interest is, let’s take a look at its advantages. 

1. It amplifies your returns

As you’ve already seen above, compound interest can amplify your return generation potential. How, you ask? Here’s an example. 

Let’s say that you wish to invest Rs. 1,00,000 for a period of 10 years at an interest rate of about 8% per annum. The frequency of compounding here is annual. At the end of 10 years, you will be left with Rs. 2,15,892. 

Compare this with simple interest, where you will only end up with Rs. 1,80,000. With compound interest, you get to earn Rs. 35,892 more than you do with simple interest. 

2.You can start off small 

Another major advantage of compound interest is the fact that you don’t have to start off with a large lump sum amount. Even minor investment amounts can give you high returns when given enough time. Here’s an example to help you understand. 

Let’s say that you start working at the age of 23. You invest 50% of your salary, which comes up to Rs. 10,000, in an investment option that gives you a return of about 8%. The compounding frequency is annual and you wish to hold the investment till your retirement age of 60. So, the tenure comes up to around 37 years. At the end of the investment period, you will be left with Rs. 1,72,456.  

What are the cons of compound interest?

In addition to providing benefits, compound interest also has a few disadvantages. Here’s a quick look at a couple of them. 

1. It is only advantageous over the long-term 

Compound interest works in your favour only when you give it a long period of time, say 10 or more years. It provides little to no advantage over the short-term. 

2. It can lead to significant financial burden 

Compound interest on borrowings or on debt can be very dangerous. When left unchecked, your debt can quickly spiral out of control, leaving you in financial ruin.