Expanded Lesson
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The Power of Compound Interest
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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.
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