Expanded Lesson
3 min read
The Power of Compound Interest
-
-
Copied link to Clipboard!
It’s no secret that compound interest can be a huge asset when it comes to your finances. But it can also be a recipe for disaster if you’re having trouble making monthly payments on your mortgage, student loans, or credit card bills.
LESSON CONTENTS
What Is Compound Interest?
Compound interest is the idea of charging interest on top of interest. Every time the principal loan amount accumulates interest, it’s then added to the principal, which then grows over time. The principal will then accumulate even more interest the next time around, which creates compound interest. This allows the principal sum to grow exponentially over a set period of time.
If you have money in a savings account, you can calculate the compound interest to estimate how much your savings will grow over time. On the other hand, compound interest can also be a danger. If you take out a loan for school or a car, your debt will collect compound interest as well. Every period, the interest will be added to the principal, which will grow exponentially over time.
As you can see, compound interest can be both a blessing and a recipe for taking on more debt. That’s why it’s important to track compound interest over time, so you can monitor your finances as they evolve.
How to Calculate Compound Interest
Knowing how to calculate compound interest is essential when it comes to monitoring your finances. The power of compound interest is its ability to grow quickly. By knowing how to calculate compound interest, you can estimate how much your savings or debt will grow over time. Use this guide to learn how to calculate compound interest on your own.
Compound interest is calculated by multiplying the initial loan amount, or principal, by the one plus the annual interest rate raised to the number of compound periods minus one. This will leave you with the total sum of the loan including compound interest. You can then subtract the initial principal and you’ll be left with the total compound interest.
The resulting equation will appear as:
Compound Interest = P [(1 + i)n – P]
P stands for principal; i stands for interest; n stands for the number of compounding periods.
If that was confusing, let’s try an example.
If we have a principal amount of $10,000 with an annual interest rate of 5% over a five-year period, the equation will stand as:
Compound Interest = 10,000 [(1 + 0.05)5 – 10,000
That comes out to $2,762.82 in compound interest over the next five years.
Luckily, we live in the 21st century where there’s an app for just about everything. You can quickly put your loan information into a compound interest calculator to see how the interest will grow, such as the calculator below.
How to Make Compound Interest Work for You
The secret to growing compound interest is having more compounding periods. For example, if you have $10,000 in savings, your money will grow faster at an interest rate of 5% over the next five years if the compound period is just six months instead of an entire year. This way, new interest will be added to the principal more often, which will increase the total at a faster rate.
It’s best to calculate the compound interest before taking out a loan or putting your money in a savings account. Based on the given interest rate, you should know exactly how much your interest will grow over time.
Compound interest all depends on the financial institution.
If you are trying to grow your savings, look for a financial institution with a compound interest rate that works for you. The longer you keep your money in the account, the faster your savings will accrue. Look for a bank or credit union with a shorter compound period to reap the most from your savings. Do the math ahead of time to make sure you are getting a good deal. Avoid taking out your savings prematurely to keep the compound interest growing.
When taking on debt, compound interest will make it harder to pay off the original loan. To reduce compound interest, make sure you are paying off some of the principal amount every month. Some people will only pay off the interest each month, especially if they are low on cash, but reducing the principal is the best way to avoid paying extra in compound interest. Make extra payments when you can to pay off the principal as soon as possible. If you fall behind on your payments, the compound interest will only get worse, so avoid taking on more debt than you can handle.
Compound interest is one of the most important money concepts to understand. To make it work for you, keep your money in the bank and choose a lending partner that can help you reach your goals.
Related Resources
View All
Expanded Lesson
6 min read
Money Management Tips for Young Adults
As a new consumer, you might not have much experience managing your money, but that’s okay. If you are looking to start good money habits now and make the most of your hard-earned money, use these money management tips to help you get started.
Expanded Lesson
5 min read
How to Track Spending
Do you get to the end of every month with no cash left, struggling to pay the final few bills and frustrated because you can’t seem to stay on budget? Learning how to track spending can help you be more aware of where your money goes throughout the month and can help prevent you from having to scramble until the next paycheck.
Expanded Lesson
3 min read
What Is a Money Market Account?
Are you ready to put your money to work for you to earn interest, but still have it readily available to access? That’s the basic money market account definition. Money market accounts offer you the option to maintain liquidity, while you watch your money grow.
Expanded Lesson
5 min read
How to Save Money
Do you work hard every week, only to see your paychecks slip away like sand between your fingers? Saving money can be difficult. The good news is that it’s never too late to start saving and you can take baby steps while you learn how to put money away. As your nest egg grows, you’ll be motivated to find more ways to boost it up and can add even more money saving tricks to your repertoire.
Expanded Lesson
5 min read
How to Budget
Making the most of your money isn’t always easy these days. Chances are you’re getting hit with expenses from all sides, which can be stressful if you don’t have a lot of money to go around. Regardless of how much money you make or what you’re looking to do with it, it’s always a good idea to learn how to budget. This will help you better manage your finances, so you can prepare for the unexpected.
Expanded Lesson
3 min read
The Power of Compound Interest
It’s no secret that compound interest can be a huge asset when it comes to your finances. But it can also be a recipe for disaster if you’re having trouble making monthly payments on your mortgage, student loans, or credit card bills.
Expanded Lesson
6 min read
College Savings Plans: What You Need to Know
Whether you’re saving for your child to go to college or planning the next chapter of your career, you have several options to choose from when it comes to paying for school. The good news is that you’re thinking about your options ahead of time, which should help you make the most of your money as you prepare to further your education. 529 plans can be confusing but learning about these programs will help you save money over time as you finance your education, regardless of where you decide to go to school.
Expanded Lesson
6 min read
Five Tips for Tax Season
Have you filed your tax return yet? If you're worried about preparing your taxes, use these tips to help get you ready for tax season.
Quick Lesson
2 min read
Do Youth Accounts Help Kids in College?
Read this article to learn how a youth account can help your kids succeed in college.
Expanded Lesson
13 min read
A Parent’s Guide to Raising Money-Smart Kids
As a parent, you might struggle with when and what to teach your children about money management. Is five too early to earn an allowance? Should you share the family budget with your children? When should teens learn about credit? These are all important questions, and it’s often not easy to know the answers. Kids have different levels of interest in financial education. But research tells us that by the age of five most children understand money and what it can do. The information below offers more specific guidelines for different age groups. Again, these are just guidelines. What decisions you make about when and what to teach at home depend on your family situation, household budget and how comfortable you are in the role of teacher.
Quick Lesson
3 min read
How-to Build Savings: Four Ways to Help Build Your Savings
Saving money can feel like a challenge. Even thinking about saving – when you’re trying to pay off existing debt – can be stressful. But, it doesn’t have to be. You can start to save more by using these strategies.
Financial Principles: Four Important Money Principles
If you could only learn four things about money, what would they be? Read this article to learn about four essential money principles that can help you take control of your finances.