What is Compound Interest?
The compound interest is the formula that calculates the amount of interest earned on trading or investing account where the amount earned is reinvested. The “compound” term is used because the investor will be reinvesting the earned amount.
One of the greatest tools you can utilize to build your wealth is compound interest. First of all what exactly is compound interest? Normally when investing a principal balance you would make a percentage return on it, this is known as simple interest. Compound interest is where you keep earning money on your principal balance as well as the money you made as simple interest. This means that your money will keep multiplying and after a while, it will start to grow exponentially.
How Does Compound Interest Work?
The amount you make as a return from compound interest depends on the frequency at which it compounds. Compound interest can be compounded either daily, monthly, quarterly or even annually. The most common compounding frequency you will see is annual (see below formula for ending balance with compound interest). So let’s say you put $1000 into a mutual fund as your principal balance. If the return is 7% annually then in your first year you will have a new balance of $1070. The next year you will earn 7% on that $1070 and so on. As you can see after a significant amount of time you will start making a good amount of interest and will see your money grow.
How is Compound Interest Calculated?
If you are interested in calculating the amount of money you will have accumulated after a set amount of time then you are in luck. There is a simple formula that can be used to calculate the amount you will have after a set amount of time, based on your principal balance and rate of return.
Compound Interest Formula
The formula for ending balance with compound interest
C= P[(1+r)^n – 1]
The definitions of these variables are listed below
C = Compound interest
P = Principle (the original balance)
r = Interest rate per period
n = The number of periods
In order for you to fully understand how to utilize this formula, I will demonstrate it using an example.
Calculating Compound Interest
Suppose you take $1000 and put it into an investment. Your rate of return is 10% and is compounded annually. I will use this formula to determine your balance after 20 years.
Plug the variables into the formula
C = Unknown
P = $1000
r = 10%
The interest rate will be converted into a decimal so 0.1 will be plugged into the formula
n = 20
Here is the formula with all of the variables substituted
C = $1000[(1 + 0.1)^20 – 1]
The last step is to plug this into your calculator! After plugging this into my calculator I have determined that the final balance under these conditions will be roughly $5728. If you were to use the same conditions while earning simple interest your final balance would be $2000 after 20 years. As you can see there is a significant difference in the earning potential between compound interest and simple interest.
Hopefully, you found this article enjoyable to read and have learned an important skill in determining your earnings on your path to financial freedom.