The eighth wonder of the world, as it is often called by accountants, compound interest can help you increase your earnings if you grasp how it works. As for those who don’t, they’re likely to end up paying it instead and become worse-off.
So what exactly is compound interest and how does it work? Read on to find out.
Defining Compound Interest
Firstly, we need to understand simple interest. It is the interest calculated solely on the original amount of money (called ‘principal’) deposited or loaned.
For instance, $1,000 loaned at a rate of 5% simple interest for a period of 4 years means:
$1000 x 5/100 x 4 = $200 interest to be paid annually (i.e. principal x interest rate x duration = interest to be paid)
Loans like home mortgages, student loans and car loans usually utilize this type of interest.
Now, moving on to compound interest.
Compound interest is calculated not just on the principal amount, but also on the amount of interest accumulated so far (hence the name compound). It is therefore, the ‘interest on interest.’
It can be calculated via the formula:
Total compounded interest = P (1 + r/n) (nt) – P
Here P is principal amount, r is the annual rate in decimal value, n is the number of annual compounding periods and t is the total number of years the money is borrowed or invested for.
So for instance if the same principal amount of $1,000 is loaned for the same period of 4 years on the interest rate of 5%, with the only exception that interest is now being compounded (annually) instead of being simple, then the interest amounts to approximately $216.
This means $16 more interest to be paid as compared to the loan on simple interest. This amount may seem small, but that’s because the principal considered here was small. For real loans of thousands of dollars, this difference lies in thousands of dollars as well!
To know the total value of a loan or investment based on compound interest at the end of its period, the following formula can be used:
FV = P (1 + r/n) (nt)
Here FV is the future value of the loan or investment (i.e. compounded interest and the principal).
In case, you wish to avoid the math, online calculators can be used instead.
Turn Compound Interest In Our Own Interest!
When investing your money, look out for options that compound money more frequently (e.g. monthly instead of annually or daily instead of monthly). This is because, naturally, the more frequent the periods, the higher interest you will accrue. Conversely, when taking a loan, take one that compounds less frequently as you will have to pay more interest on a loan that is compounded monthly instead of annually and so on.
Compound interest is indeed a powerful concept. Now that you have learned how it works, make sure to use it to strengthen your finances and make that interest work for you!