How compound interest works
Compound interest is interest earned on interest. Because each period’s earnings join the principal, the balance grows on a curve rather than a straight line — and the frequency of compounding quietly changes the outcome.
Formula
A = P × (1 + r/n)^(n × t)
- P — the principal you start with
- r — annual interest rate as a decimal
- n — compounding periods per year (4 for quarterly, 12 for monthly)
- t — number of years
- A — the maturity amount
Simple versus compound, side by side
₹1,00,000 at 8% for ten years earns ₹80,000 as simple interest, taking the balance to ₹1.80 lakh. The same deposit compounded annually reaches about ₹2.16 lakh, and compounded quarterly about ₹2.21 lakh.
The extra ₹41,000 is entirely interest that itself earned interest. Stretch the period to twenty years and the quarterly-compounded balance passes ₹4.87 lakh while simple interest reaches only ₹2.60 lakh.
Why compounding frequency matters
More frequent compounding means interest joins the principal sooner. On that ₹1 lakh at 8% for ten years, annual compounding gives ₹2.16 lakh, quarterly ₹2.21 lakh, and monthly ₹2.22 lakh.
The gaps are modest over short periods but widen with time and with higher rates. This is also why banks quote an annual equivalent or effective yield alongside the nominal rate for deposits that compound quarterly.
A quick mental shortcut
The rule of 72 estimates how long money takes to double: divide 72 by the annual rate. At 8% that is about nine years; at 12%, six years. It is accurate enough for planning conversations and needs no calculator.
The same rule works in reverse for inflation. At 6% inflation, prices double in roughly twelve years, which is why long-term goals need a growth assumption comfortably above the inflation rate.
What to remember about tax
Compounding is calculated on gross interest here. For a bank deposit, interest is taxable as income each year even though you receive it only at maturity, which reduces your effective compounding.
Instruments with tax-free or deferred taxation compound faster in practice for the same headline rate, which is worth factoring in when comparing options.
Example: ₹1 lakh at 8% for 10 years
- Principal
- ₹1,00,000
- Rate
- 8% p.a.
- Simple interest result
- ₹1,80,000
- Compounded annually
- ≈ ₹2,15,892
- Compounded quarterly
- ≈ ₹2,20,804
- Compounded monthly
- ≈ ₹2,21,964
Compounding adds roughly ₹36,000 to ₹42,000 over simple interest depending on frequency. The longer the term, the larger that gap becomes.