What Is Compound Interest?
Depending on your financial situation, compound interest can work for or against you. Every time the principal loan amount accumulates interest, it’s then added to the principal, which then grows over time. The principal accumulates even more interest the next time around, creating compound interest. This allows the principal sum to grow exponentially over a set period of time.
Understanding Compound Interest
Compound interest can work for or against you, depending on your financial situation. The money in a savings account will accrue compound interest, which will help you grow your savings over the long term. If you have money in a savings account, you can calculate the compound interest to estimate how much your savings will grow over time. The interest rate will compound annually, at which point the interest accrued will be added to the principal balance in the account, so you will earn even more in interest in the following year.
On the other hand, compound interest can pose a risk. If you take out a loan for school or a car, your debt also collects compound interest. Every period, the interest is added to the principal, which grows exponentially over time. That’s why paying off the balance owed and interest that has accrued before the end of the compounding period is important.
As you can see, compound interest can be both a blessing and a recipe for taking on more debt. That’s why it’s important to track compound interest over time, so you can monitor your finances as they evolve.
How to Calculate Compound Interest
Knowing how to calculate compound interest is essential to monitoring your finances. The power of compound interest is its ability to grow quickly. Knowing how to calculate compound interest allows you to estimate how much your savings or debt will grow over time. To understand compound interest, look at the following example:
Suppose you have $1,000 in a savings account with a 5% interest rate and a 12-month compounding period. After one year, the original investment will earn $50 in interest (1,000 x 0.05 = $50). The interest accrued is added to the principal balance for a total of $1,050. After another 12 months, the account earns $52.50 in interest (1,050 x 0.05 = $52.50). The interest accrued is added to the principal and so on until you finally deduct money from the account.
Compound interest is calculated by multiplying the initial loan amount, or principal, by one plus the annual interest rate raised to the number of compound periods minus one. This will leave you with the total sum of the loan, including compound interest. You can then subtract the initial principal and you’ll be left with the total compound interest.
The Compound Interest Formula
Use the following equation to calculate compound interest:
Compound Interest = P [(1 + i)n – P]
P stands for principal; i stands for interest; n stands for the number of compounding periods.
Let’s try using the equation in an example:
If we have a principal amount of $10,000 with an annual interest rate of 5% over a five-year period, the equation will stand as:
Compound Interest = 10,000 [(1 + 0.05)5 – 10,000
This equals $2,762.82 in compound interest over the next five years.
Luckily, we live in the 21st century with an app for almost everything. You can quickly put your loan information into a compound interest calculator to see how the interest will grow, such as the calculator below.
Compound Interest vs Simple Interest
The difference between compound interest and simple interest lies in how the interest rate is applied.
With simple interest, the interest rate only applies to the principal balance. If you have a savings account of $1,000 and the interest rate is 5%, you will earn $50 every year in interest. The formula for calculating simple interest is as follows:
Simple Interest=P x I x N
P = Principal
I = Interest rate
N = Term of the loan
If you keep the savings account open for five years, the total interest would be $250 (1,000 x 0.05 x 5).
Compound interest is applied to both the principal balance and all the interest accrued during the previous compounding periods. The interest accrued will be added to the principal balance at the end of every compounding period, so you earn more in interest the longer you keep the account open.
Factors That Affect Compound Interest
You can earn or owe much more in interest when you have an account with compound interest, but several factors can affect how much you accrue in interest.
The first factor is the principal balance. The more you have in the account, the more you will accrue in interest. The second factor is the interest rate, which will be applied to the principal at regular intervals.
The third factor is the length of the compounding period, which refers to how often the interest accrued gets added to the principal balance. The compounding period can last anywhere from a year to as little as one day. The shorter the compounding period, the faster the principal balance accrues.
The fourth factor is time. The longer the account remains open, the more interest accrues, and the amount of accrued interest increases after every compounding period.
How to Make Compound Interest Work for You
The secret to growing compound interest is more compounding periods. For example, if you have $10,000 in savings, your money will grow faster at an interest rate of 5% over the next five years if the compound period is just six months instead of an entire year. This way, new interest is added to the principal more often, which increases the total at a faster rate.
Calculating the compound interest before taking out a loan or putting your money in a savings account is best. Based on the given interest rate, you should know exactly how much your interest will grow over time.
Compound interest all depends on the financial institution.
If you are trying to grow your savings, look for a financial institution with a compound interest rate that works for you. The longer you keep your money in the account, the faster your savings will accrue. Look for a bank or credit union with a shorter compound period to reap the most from your savings. Do the math beforehand to ensure you get a good deal. Avoid taking out your savings prematurely to keep the compound interest growing.
Compounding interest will make it harder to pay off the original loan when taking on debt. To reduce compound interest, make sure you are paying off some of the principal amounts every month. Some people will only pay off the interest each month, especially if they are low on cash, but reducing the principal is the best way to avoid paying extra in compound interest.
Make extra payments to pay off the principal as soon as possible. If you fall behind on your payments, the compound interest will only worsen, so avoid taking on more debt than you can handle.
Compound interest is one of the most important money concepts to understand. To make it work for you, keep your money in the bank and choose a lending partner to help you reach your goals.
