- Compound interest can help or hinder your goal.
- The three factors that influence the final cost are interest rate, balance and time.
- To know the effects of compound interest, you need to use the correct mathematical formula or online calculator.
- This article is for small business owners who want to maximize their savings and minimize their financial obligations.
The power of compound interest can work for or against you as a consumer. If you have a deposit account at a bank, you will earn interest on the amount you deposited as well as the interest your money has already earned. Conversely, if you have credit card debt and have a month-to-month balance, interest will be added to the amount you owe, which has already accrued interest.
Here are the factors that determine how much compound interest will increase the value of your assets or liabilities:
- Interest rate
- A length of time
Whether you’re saving or borrowing money, it’s always wise to track the effect finance charges will have on the balance. Unless you’re a math whiz, you won’t be able to work out the numbers in your head. You can calculate compound interest yourself with a mathematical formula or plug the numbers into an online calculator. Whichever way you do it, knowing how much compound interest can help you reach your financial goals or can hinder your progress is a worthy undertaking.
What is compound interest?
Interest is the fee a lender will charge you to use their money. Instead of simply repaying the amount you borrowed, a fee is added to the balance. Lenders charge interest on installment loans, credit cards and other financial obligations. Banks also pay interest to people who deposit money in their institution because you allow them to use the money to make loans.
There are many ways to calculate interest, but the compound interest method is most commonly used for credit cards and bank deposit accounts. With it, interest accrues on the initial capital as well as accrued interest from a deposit or debt.
By compounding interest, a principal amount can grow at a faster rate than if the simple interest method were applied. This is because simple interest is based entirely on the percentage of the principal amount and not on the interest applied. This method is often used for auto loans, term loans, and some student loans.
Is this starting to seem complicated? Essentially, compound interest works like this: Imagine depositing money in a savings account and leaving it there. The bank will first add interest to the amount you have deposited. The next time the bank assesses interest, it will be on the amount you originally deposited more additional interest. This means you make money on the principal plus what the bank has already given you.
For this reason, compound interest on a savings account can help you build up a nice nest egg with relatively little effort on your part.
The downside of compound interest occurs when you owe money. For example, imagine that you have accumulated a large bill on your business credit card. Instead of paying in full, you pay in part and transfer the rest to the next month. The bank will add interest to this debt. If you continue to push this balance, the next time interest is calculated, it will be on the balance that has already increased with the interest that was added the previous month.
Therefore, compound interest on debt can add up quickly. The bank charges you for the convenience of rolling over the balance.
Simple Interest vs Compound Interest
To see how compound interest is calculated differently than simple interest, simply do a side-by-side comparison with the same terms. Here’s what it would be like for each method, on $4,000, with an annual interest rate of 8% over a four-year period.
Example of simple interest
Simple interest is calculated by multiplying principal (P) by rate (R) by time (T). This would be the calculation for the example above:
$4,000 x 0.08 x 4 = $1,280
So in four years, the total interest would be $1,280 and the balance would increase to $5,280.
Example of Compound Interest
Compound interest is calculated by applying interest to the principal plus accrued interest after each year. Break down :
- After the first year, P x R x T (which in this case is 1) = $320, the new principal would be $4,320.
- At the end of the second year, P x R x T = $345.60, which adds to the old principal, creating a new principal of $4,665.60.
- At the end of the third year, P x R x T = $373.25, which added to the old capital is $5,038.85.
- Applying this formula again for the fourth year yields a new principal of $5,441.96, or a total interest earned of $1,441.96.
Compared to simple interest, compound interest is $161.96 more.
Compound interest formula
The example above illustrates the concept of compound interest, but you can use another formula that is much simpler than calculating for each year and adding. This is the formula:
P x (1+r)you = Future Value (FV)
In this formula, “P” represents the present value, “r” represents the interest rate as a decimal, and “t” is the time period expressed as an exponent. This formula can also be used to roll back, which is useful when you want to set a savings goal of a specific amount of money over a set period of time. In other words, if you know your target FV and want to determine the present value you need, you can work the formula backwards:
P = VF ÷ (1+r)you
Point: While you can have fun doing the math yourself using these formulas and a financial calculator, you can save time and ensure accuracy by using an online calculator. One of the best is the compound interest calculator offered by the United States Securities and Exchange Commission.
Components of Compound Interest
When you want compound interest to work in your favor because you’re building funds for the future, keep the components of compound interest in mind. To grow your money, you will need the following components.
- High interest rate: This should be the highest interest available that you can qualify for. Deposit account rates are tied to rates set by the Federal Reserve, though they fluctuate depending on the bank, so it’s best to shop around.
- High Balance: You’ll also want to add to your balance so it grows, not just with interest, but with regular deposits.
- Long period: The longer you let the funds grow, the more compound interest will be added to the principal. With regular investments, a savings account can grow to quite a large amount. The younger you are when you start saving and contributing, the more time capitalization can be to your advantage. Although results may seem slow at first, persistence can really pay off. For example, contributing $5,000 annually to an IRA for 45 years, with an average return of 8%, can generate retirement savings of more than $1.93 million, or eight times the amount contributed.
The flip side of growing money, of course, is losing it. This is easy to do when compound interest is calculated on a debt. Again, keep the components of compound interest in mind. This time you will need the following components.
- Low interest rate: Look for the credit product that has the lowest possible interest rate. While it’s best to keep debt at zero, if you need or want to pay it off over time, a low interest rate is key.
- Low Balance: Using a credit product that calculates interest using the compound interest method can become an extremely expensive undertaking when the balance is high. Do your best to only charge the amount you can afford to pay in full by the due date.
- Short period of time: If you need to pay off a large balance in installments, make your payments as large as possible so you don’t extend the date unnecessarily. Credit card debt of $5,000 with an interest rate of 25% that you pay over five years will cost you $3,805 in compound interest. If you reduced the term to 12 months, the capitalization would be $702.
Compound Interest: A Powerful Friend or Foe
Ultimately, compound interest is a powerful way to increase or decrease the value of your savings or debt. You have considerable control over this process. By calculating what you could earn with regular deposits, you can plan your dreams, from starting your own business to retiring in luxury. And by calculating what you could lose by allowing a balance to earn excessive interest, you can make better decisions when shopping and managing your accounts. The choice is yours.
Elaine J. Hom contributed writing and research to this article.