If you’ve made any investments, chances are you’ve heard the term compound interest. Maybe someone at the bank explained it to you, maybe not. Maybe you’ve heard of it when applying for a mortgage or car loan. Anytime you borrow or invest money, you will pay or be paid interest.
To my surprise, there isn’t a “for dummies” book for compound interest or even interest and how it relates to finances. Luckily, other’s have picked up the slack and created some great books to help you put your money to work for you.
So if this 700 word post is not enough and you want to have 66 full pages of compound interest, the book “Compound Interest: 10 Financial Truths to Protect Your Wealth (The Other Side of the Coin)” by Will Duffy is a great place to start. You can check it on Amazon here.
So what is compound interest?
The simplest explanation of compound interest is the interest earned on interest previously earned that you have reinvested.
For example, you invest $1,000 and it earns 5% interest, or $50 per year. In a compound interest scenario, that $50 would be reinvested and become part of your investment.
*Note: The initial $1,000 investment is called the principal.
Now, you have $1,050 invested. At the same 5% interest rate you’ll now get $52.50. So your total after two years is $1,102.50.
Although we all start small and the numbers are little boring. It becomes much more interesting when the numbers become big.
This contrasts with simple interest, where interest is calculated by multiplying the principal times the interest rate times the number of days elapsed.
This is often how car loans are calculated and why amortization schedules, or documents that outline how much interest is included in each payment period, are useful for consumers. Paying off principal early will help lower future interest payments.
How do I calculate compound interest?
First, you need to know how many times your interest will compound during the term of the investment. To find out the amount you will have at the end of the first period, you can just do some simple multiplication like in our example above.
Investment 1st period = Principal + (Principal x Interest Rate)
$1050 = $1000 + ($1000 x 0.05)
For your next period, you will have a new principal amount because you now have what you made and reinvested.
Investment 2nd period = Investment 1st period + (Investment 1st period x Interest Rate)
$1102.50 = $1050 + ($1050 x 0.05)
You can continue to do this for each compounding period or you can use the formula below.
Total return = Principal + Principal [(1 + Interest rate)number of periods – 1]
Assuming our example investment has three compounding interest periods, the total investment would be calculated as follows.
Total return = $1000 + $1000 ((1 + 0.05)3 – 1)
Over the life of the investment, you would end up with $1157.63. As you can see, the higher the number of compounding periods, the larger your investment will grow. For help with the math, there are a variety of compound interest calculators online or you can use Excel.
How does compound interest affect me?
It is important to know how an investment will accrue interest. Certificates of Deposit, or CDs, money market accounts, and other investments should outline what type of interest they will generate and what the compounding period will be.
Other places that you will find compound interest are on loans, mortgages, and credit cards. In those cases, you will pay interest based on not only the initial amount that you borrowed but any additional interest that is added to the account.
This can be especially problematic if the interest rate is very high, as it will make it exponentially harder to pay off the initial principal as it grows over time. The Truth in Lending Act requires that all lenders disclose how interest is calculated, including whether it is compound interest, in the terms of the loan.
Whether you are investing your own principal or borrowing via a loan or credit card, you should understand how you will be paid or pay interest. Not only will it help you make an informed decision about what account or service to use, it will also allow you to adequately outline your future budget. Now that you know the basics of compound interest, you can approach your financial future with newfound confidence.