Calculating compound interest
Compound interest can make savings grow faster or make loans more expensive. Learn what it is and how to utilize it.
When you deposit money in a savings account, a money market account, or other type of deposit account, you can generate interest, that is, a percentage of the account balance that the financial institution periodically pays you for allowing it to use your money. When you get a loan or contract a credit card debt, the interest works in the opposite way: you periodically pay the financial institution a percentage of your outstanding balance for the privilege of using its money.
Capital and accumulated interest determine compound interest. If you deposited $1,000 into an account with an annual interest rate of 2%, you would earn $20 ($1,000 x 0.02) of interest in the first year. Assuming that the bank capitalizes interest annually, you would earn $20.40 ($1,020 x 0.02) in the second year. (Most banks capitalize on interest with a much greater frequency; we choose annual capitalization to simplify this
On the other hand, simple interest is calculated only on the capital. IIf the preceding account paid simple interest, you would get $20 instead of capitalization advantages.
Your savings can expand quickly when interest is based on your growing balance.
In the case of the money you borrow, the capitalization may harm you. Capitalization-based credit card and loan accounts calculate interest based on your capital and prior interest. . Capitalization-based credit card and loan accounts calculate interest based on your capital and prior interest. You may end up paying more, or you may need more time to settle your balance.
Learn how compound interest affects earnings and payments.
Calculating compound interest?
Regardless of whether it is the interest you will earn or the interest you will pay, the compound interest can be calculated by using the following formula:
C (1+t/n)nu – C = x
… in which
x equals compound interest
C = capital (the amount of the initial deposit or loan).
t is the annual interest rate.
n = the number of capitalization periods per time unit.
u =investment or borrowing time.
Let’s use an example in which you generate interest. Suppose you deposit $5,000 in a savings account with an annual interest rate of 5%, which is capitalized monthly. This deposit would generate $3,235.05 in interest at the end of a 10-year period. The breakdown of the mathematical calculation is as follows:
C (1+t/n)nu – C = x
x = 5,000 (1+0.05/12)12×10 – 5,000
x = 5,000 (1.00416667)120 – 5,000
x = 5,000 (1.64701015) – 5,000
x = 8,235.05 – 5,000
x = 3,235.05
During that 10-year period, your deposit would increase from $5,000 to $8,235. The same account, if it generated simple interest, would increase to only $7,500.
Of course, if you don’t like to do calculations with numbers, you can use an online calculator. Calculators can be particularly useful when making regular deposits or payments to your accounts since your balance will change over time.
The frequency of capitalization is particularly important for these calculations, since the higher the number of capitalization periods, the higher the compound interest.Financial organizations can capitalize interest daily, but banks capitalize savings and money market accounts daily.
Capitalize CD interest daily, monthly, or semiannually. . In the case of credit cards, capitalization often occurs monthly or even daily. The most frequent capitalization favors you when you are the investor, but it is a disadvantage when you are the borrower.
How compound interest can impact your financial planning
Since compound interest can be favorable (if you are the investor) or unfavorable (if you are the borrower), it is important to take into account the impact that it can have on your financial plans.
To fully reap the rewards of compound interest, you must save. Choose deposit and investment accounts that offer compound interest, and do your best not to make withdrawals so that the interest has the opportunity to really accumulate.
To avoid paying compound interest, apply for loans that charge simple interest. Many large loans, for example, mortgages and vehicle loans, use a simple interest formula. On the contrary, credit cards and some other loans often use compound interest. Therefore, you must use credit cards prudently, and you must make sure to settle the balance on your statement every month.
As you become more familiar with compound interest, you will be able to take advantage of it to your advantage while you establish your wealth and reduce your debt to a minimum.
