A healthy lifestyle means ensuring your finances are in good health, too. By understanding the magic of compound interest, you can catapult your financial standing. Depending on how it is used, though, compound interest can be your best friend or worst enemy. With a compound interest calculator, loan calculator, or interest calculator, you can easily find out how much money you are gaining or losing through compound interest. Read on to find out what is compound interest, how compound interest is calculated, and how to use the Rule of 72 to double your money.
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What is Compound Interest?
Compound interest is applied in savings, investing, loans, and credit cards. It is interest applied to a principal and its interest. The principal is a person’s initial investment, loan, or credit card balance.
Savings, investments, loans, and credit cards can also accumulate simple interest, but this is not as common as compounding interest. Simple interest adds interest to the principal amount only, as opposed to adding interest to interest accumulated.
If interest is compounded on savings and investments, your money will grow exponentially. When interest is compounded on a loan or credit card, by contrast, you may have more difficulty paying it down.
Compound interest is applied most often with:
- Savings accounts
- Money market accounts
- Personal loans
- Credit cards
Simple interest is applied most often with:
- Student loans
- Real Estate Mortgages
- Car loans
How is Compound Interest Calculated?
Compound interest will be greater where compounding periods are higher. A compounding period is the span of time between when interest was last added and when it will be added again. This is part of the magic of compound interest.
For example, $10,000 compounded twice a year at 5% will earn more money than $10,000 compounded once yearly at a higher rate. Here is how it works.
Suppose, in January, person A invests $10,000 at an expected 10% interest, compounded annually. At the end of the year, Person A will have $11,000. This can be calculated by multiplying $10,000 by .10, and then adding that number to the initial $10,000.
Person B also invests $10,000, but at an expected return of 5%, compounded semi-annually (twice per year). After 6 months, person B will have $10,500. At the end of the year, interest will compound on that $10,500 rather than on the initial $10,000, giving Person B $11,025. This can be calculated by multiplying $10,000 by .05, then adding that number to the initial $10,000 for the first interest payment. Interest is compounded at the second interest payment, where $10,500 is multiplied by .05, for a return $25 higher than what Person A received.
Compounding periods are particularly important to keep in mind when paying down loans or credit cards. If you do not currently know how often your interest is compounded, find out. Most loans that use compound interest are compounded monthly. Most credit cards compound interest daily. Rarely, continuous compounding is used, where interest accumulates every instant.
Compound Interest Formula
Calculating compound interest is not normally as simple as the calculations used in the examples above. Most loans and investments occur over years, with different compounding periods and additional payments or additional investments made. To calculate how much money you are losing or gaining, you will likely need a compound interest calculator, or, you can use a compound interest formula to do the math by hand.
A simple web search will yield several compound interest calculators. Ensure you are using a compound interest calculator, not a simple interest calculator.
The formula for calculating the future value of an investment using compound interest is as follows:
A = P (1 + r/n) (nt)
The objective is to find “A”, where,
A = future value of loan or investment, including interest
P = principal (initial amount invested, or amount left on loan)
r = annual interest rate, expressed as a decimal
n = number of compounding periods per year
t = time, or, number of years for which money will be invested (or loaned)
The formula above will yield compound interest plus principal. To find just the total compounded interest, use the formula below:
P (1 + r/n) (nt) – P
The Rule of 72
The Rule of 72 is a way to estimate how long it will take to double your money at a given interest rate, and this is a much simpler formula. Simply divide 72 by the interest rate. This gives a remarkably accurate, though not exact, answer.
For example, suppose you invest $10,000 at an expected 10% interest rate. You want to know how long it will take to double your money. Simply divide 72 by 10 to get 7.2 years.
This formula can also be run in reverse. If you have a set period over which you need to double your money, you can determine the approximate interest rate needed to make that happen. Simply divide 72 by the number of years to find the rate needed to meet that goal.
To double your $10,000 in 5 years, rather than waiting 7.2 years, you will need an interest rate of approximately 14.4%. This is found by dividing 72 by 5.
As you can see, the Rule of 72 works no matter what your investment amount. To find exact numbers, however, use the compound interest formulas.
Compound interest on investments or savings can easily be offset by interest compounding on your loans or credit cards, and vice versa. The best rule of thumb is to seek simple interest on loans and compound interest on savings and investment vehicles.
Pay close attention to how often your money is compounded. Since most credit cards compound their interest daily, pay these off each month before the compounding interest makes payments too difficult to handle. Find out how often any loans are compounding, and make additional payments towards paying down the principal whenever feasible to minimize compound interest accumulation. Where possible, choose investments with higher compounding periods. Apply the Rule of 72 to find expected returns that work for you. Armed with a basic understanding of the magic of compound interest, you will be on your way to securing your good financial health.
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