What is compound interest and how do I calculate it?
In a low interest rate environment, growing your money can be difficult. One way to make your money grow is to take advantage of compound interest. So the sooner you start saving, the more you could grow through capitalization.
Banks use interest rates to encourage customers to open savings accounts and term deposits. As a general rule, the higher the interest rate, the more your money will grow. Financial institutions calculate interest as simple or compound interest.
What is simple interest versus compound interest?
Simple interest offers a fixed rate over a specified period. For example, if you invest $ 5,000 at 1% interest for a year, you will receive $ 50 in interest at the end of the year.
On the other hand, compound interest earns interest on the interest already earned on your savings. Most term deposits and savings accounts offer compound interest. You don’t have to wait until the end of the term to receive interest. You can choose to receive it daily, weekly, monthly or quarterly, depending on the type of account. This means that your savings grow faster when interest is compounded.
How to calculate compound interest
An easy way to calculate compound interest is to use the following formula:
A = P * (1 + r) ^ n
- A = final amount
- P = principal
- R = interest rate
- N = number of periods
To calculate monthly compound interest on a savings account, divide the interest rate by 12 and replace N with the number of months you invest.
Here is an example to help you understand. Suppose you invest $ 10,000 for two years at the rate of five percent per annum and the interest is compounded monthly. Using the formula above, the closing balance after two years is:
A = $ 10,000 * (1 + 0.0042) ^ 24 = $ 11,049.41
You should divide the annual interest by five percent by 12 because the interest is compounded monthly. In addition, the number of periods is 24 months because the investment horizon is two years.
How to increase savings using compound interest?
In low interest rate situations, your savings may grow only with inflation. But you can increase your savings by regularly adding money to your account when it is affordable. The more the deposit amount increases, the higher the interest paid. With a disciplined and diligent savings plan, you can grow your money for the long haul.
What should you know when calculating compound interest?
- First of all, you need to know the amount of the initial deposit, also known as the principal. This is the amount on which interest is calculated.
- Then the interest depends on the duration of the investment. The longer the period, the higher the interest paid.
- Another factor that determines your return is the interest rate, which is usually the standard annual rate. Do not confuse the rate with a bonus or introductory interest rate that you might receive when opening the account.
- You will need to check how often interest is calculated, whether it is daily, monthly or annually. Generally, your money will grow faster if interest is paid more frequently.
- Finally, the interest depends on how often you deposit money into your savings account. For example, if you receive additional funds via a Christmas gift or bonus, depositing the money into your account will help you earn more interest.