How to Calculate Compound Interest—A Quick Reference Guide

how to calculate compound interest

Do you sometime wish you lived a few centuries ago when life was simpler? How sure are you?

Yes, today’s modern society has developed into quite an interesting environment. Unfortunately, much of what you do each day—work, hobbies, lifestyle, the car you drive—is determined by one thing: Money.

If you don’t have a enough of it it’s bound to make life more difficult. But in our modern—complicated—age you have a unique resource: Easy access to banks and other financial institutions. When you use these correctly you’ll quickly get ahead of the game.

Of course you need knowledge if you want to understand and utilize a resource properly. Below we’ll clarify a specific topic so you can start seeing positive results: Compound interest.

What is Compound Interest?

The focus word is ‘compound’.

In this scenario interest isn’t only calculated based on an original amount, but the amount that has been compounded. Imagine how a snowball gathers snow as it rolls. Money—as an asset or a liability—can grow too because many financial agreements incorporate interest.

Each time interest is calculated it’s not done based on the original amount, but the compounded amount.

How Compound Interest Works FOR or AGAINST You

Above we stated that this relates to both assets and liabilities.

When you learn how to calculate compound interest (see below) you’ll quickly realize how many scenarios it relates to. You’ll be at the winning end when the bank pays you compound interest as you’ll earn more interest each cycle. Your interest amount is calculated on your original amount you invested as well as the interest you earned in the last period.

However, when you’re paying compound interest it can get out of hand. Even if you don’t borrow any more from the bank your calculated interest after each period becomes more-you’re paying on the original loan as well as interest incurred if you don’t pay enough to bring that amount down. This results in a much larger repayment than you originally budgeted for.

Why Do You Need This Information?

Why is it so helpful to know how to calculate compound interest? Let’s refer to the two situations mentioned above.

Firstly you can budget more effectively when you realize how your bank balance will grow. This also shows the benefit of leaving your money in the account, rather than using it. The few extra dollars will come in handy. Think long term, don’t withdraw that interest every month and enjoy the results.

This also shows the earlier you start saving the better.

Secondly, you can see if you let your interest compound your loan amount, you’ll pay much more than you originally borrowed. Your tip: Determine just how much you need to pay off at the end of each period so you repay the lowest possible overall amount. Pay more – not the minimum premium. If you don’t, compound interest will quickly escalate the loan amount.

How to Calculate Compound Interest

The experts did the work and now you can simply use their easy to understand formula.

What You Need

  • Principal (P), meaning the original amount
  • Interest rate (r)
  • Number of periods for every year—this can be 12 (months) or 52 (weeks) (n)
  • Timeline, relating to the period over which the money will be compounded (t)

The Formula

The result (A) will be based on:

P(1 + r/n)nt

Practical Example

To imagine how this can impact your current savings—or debt—let’s make it practical.

For an amount of $10 000 on which you earn 5% interest over a period of 3 years, your equation will look like this (we’ll use 12 monthly periods for our example):

A=10 000(1+5/12)ˆ(12×3)

If you started with an investment of $10 000 and never drew any of your savings or the interest that accumulated, you can have $11 614.72 after a three year period.

An Easy Alternative

The formula is easy enough if you have a calculator nearby, but here’s another reason why you should be glad you’re  living in the 21st century: There’s an app for everything.

If you want to determine how big a risk you’re taking (when taking out a loan) or whether it’s worth leaving your savings in the bank, simply use online compound interest calculators. There are many free versions and if you’re not a mathematics expert you can now guarantee accuracy.

You can also use a spreadsheet to determine the outcome.

Additional Applications

How Long Until You Reach Your Goal?

It doesn’t stop there. Knowledge about how to calculate compound interest can also help you plan more effectively for your future.

Do you need a specific amount of money to pursue a career goal? You can quickly determine how long it will take you to reach said goal by using the Rule of 72. This method tells you how quickly your money can double:

  • Determine your bank’s interest amount
  • Divide 72 by the interest amount
  • The answer is the number of years until you double your cash

What Interest do You Need?

You also need to vet banks and pick one that will give you the desired result by the time you need that cash:

  • Determine in how many years you need the money
  • Divide 72 by that number
  • The answer is the minimum interest you need that will enable you to reach your goal

Can you see how much smarter you can work with your money with the help of a little math?

Make Sure it Works For You

Whether you use the formula, ask an expert or use apps, you now don’t have any reason not to let your money work better for your sake. A little knowledge puts you back in control:

  • Don’t allow personal loan vendors to swindle you by not telling you the whole truth. Calculate the true repayment amount so you know whether it’s worth it.
  • Use real numbers to motivate you to keep on saving. A withdrawal means you’ll enjoy the interest you’re paid on your investment momentarily. But in the long run you’ll have less to show for your efforts.
  • Vet loan providers and their interest rates before you commit so you know you’ll reach your goals.

[Conclusion]

Don’t feel at the mercy of today’s society, your bank balance or financial institutions. A little knowledge helps you make the most of your money.  

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