How Do You Calculate Compound Interest?
The simplest way to calculate compound interest is year by year. You will need to know some information about your loans to calculate the compound interest. The first things you’ll need to know are the initial investment, represented in the equation as P, and the interest rate, represented by r. You’ll also need to know the number of times your interest rate is compounded (n) each year. For example, a loan with monthly compounding interest would compound 12 times in one year. One with interest that compounds quarterly would do so four times. The last thing to know is the length of your loans in years (t). Once you have all that information, you can plug it into the compound interest formula: A = P (1 + r/n)nt You can perform the math on a calculator or in a spreadsheet to get the total amount of money you will have or owe at the end of your investment or loan.
How Compound Interest Works
The combination of time and compound interest is a powerful financial tool that can work hard for you when you’re saving for retirement, education expenses, or other long-term goals. It can also work against you on your business line of credit or other financing arrangements.
Example of Compound Interest
Let’s look at a retirement plan, saving $10,000 per year beginning at age 35. Assuming you get 4% interest for the next 30 years, our calculator shows that you’d have $560,849 when you retire. Your $300,000 contribution will have earned $260,849 in interest. If, instead, you started five years earlier at age 30, you would have $736,522. For an additional $50,000 in contributions ($10,000 per year), your balance would be $175,673 more.
Compound Interest vs. Simple Interest
The difference between compound and simple interest is how it is added to the principal balance. Compound interest adds interest due to the principal balance, and simple interest doesn’t. Simple interest is calculated by the principal time, the interest rate, and the amount of time on your loan. For example, if you had a $10,000 loan with 5% interest rate for two years, the accrued interest would be $1,000. No interest is added to the principal balance. If the interest in the same loan was compounded monthly, your total interest would be $1,049.41.
