What is Compound Interest ?
It is interest computed on the initial principal amount. It also includes interest accumulated during the previous periods of a loan or deposit. It is like an “interest on interest”. With compound interest, the sum grows faster than with simple interest. The rate of compound interest accumulation depends on how frequently it is compounded; if the number of compounding periods is higher, the compound interest will be greater.
Breaking Down Compound Interest
To calculate compound interest, you use this formula:
Compound interest = total amount of principal and interest in future (future value) less principal amount at present (present value)
= [P (1+i)n] – P
= P [(1+i)n – 1]
P – principal
i – percentage nominal annual interest rate
n – number of compounding periods
How Compound Interest Rate Grows
Compound interest considers interest accumulated in previous periods so the interest amount is different in all of the years, unlike with simple interest.
Compounding Periods Matter
Compounding periods make a huge difference in the calculation of compound interest. More compounding periods mean a higher compound interest amount.
Compound Interest Calculators
There are so many compound interest calculators online and some of them are free.
FinancialCalculators.com offers a free compound interest calculator. It is very simple and offers all kinds of choices as far as compounding frequency is concerned.
The U.S Securities and Exchange Commission operates a website, Investor.gov, that also offers a free calculator. Although the calculator is simple to operate, you cannot input monthly extra deposits to the principal.
TheCalculatorSite.com is another place where you can get a free calculator for compound interest. However, it has fewer features. You can use different currencies and factor in monthly withdrawal or deposits.
How Often Do You Compound Interest?
There are no limitations when it comes to the frequency schedule, anything from daily to annually is allowed. Financial instruments adhere to certain standard schedules of compounding frequency.
Bank savings accounts use a daily compounding schedule.
Time Value of Money
If you are an investor interested in optimizing your wealth allocation and income, you need to understand the time value of money.
This is the formula for getting FV (future value) and PV (present value):
FV = PV (1+i)n
PV = FV / (1+i)n
Compound Annual Growth Rate (CAGR)
The CAGR is commonly used for many financial applications that need the computation of a single rate of growth over a length of time.
The Magic of Compounding
Compounding is disadvantageous when you take out a loan with a very high interest rate. The magic of compounding, however, can be beneficial in your investments, especially when you invest in mutual; funds.
How to Tell Between Simple and Compound Interest
Lenders are required by the Truth in Lending Act (TILA) to disclose the terms of a loan to any potential borrower—this includes whether the interest is compound or simple and the total amount of interest that the borrower will pay throughout the life of a loan.
You can also compare the interest rate of a loan to the annual percentage rate (APR).