The power of compound interest can work either 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 on the interest your money has already earned. Conversely, if you have credit card debt and carry a balance from month to month, interest will be added to the amount you owe, which has already accrued interest.
These are the factors that determine how much compound interest will increase the value of your assets or liabilities:
Whether you are saving or borrowing money, it’s always wise to track the effect that financing fees will have on the balance. Unless you’re a math wiz, though, you won’t be able to compute the figures in your head. You can work out the compound interest on your own with a mathematical formula or plug the numbers into an online calculator. However you do it, knowing how much compound interest can help you achieve your financial goals or can hinder your progress is a worthy endeavor.
Interest is the fee a lender will charge you for allowing you to use their money. Instead of just repaying the amount you borrowed, a charge is added to the balance. Lenders apply interest to installment loans, credit cards and other financial obligations. Banks also pay interest to people who deposit money at their institution because you are letting them use the money to make loans.
There are many ways that interest can be calculated, but the compound interest method is most often used for credit cards and bank deposit accounts. With it, interest accrues on the initial principal as well as the accumulated interest of a deposit or a debt.
By compounding interest, a principal amount can grow at a faster rate than if the simple interest method were applied. That’s because simple interest is based entirely on the percentage of the principal amount and not on any of the applied interest. This method is often used for car loans, term loans and some student loans.
Is this starting to sound complicated? In essence, compound interest works this way: Imagine depositing money into a savings account and leaving it there. The bank will first add interest to the amount you deposited. The next time the bank assesses interest, it will be on the amount you originally deposited plus the added interest. That means you are earning money on the principal plus what the bank has already given you.
For this reason, compounding interest on a savings account can help you build a nice nest egg with relatively little effort on your part.
The downside of compounding interest occurs when you owe money. For example, imagine you ran up a sizable bill on your business credit card. Instead of paying in full, you pay partially and move the remainder to the next month. The bank will add interest to that debt. If you continue to push that balance off, the next time interest is calculated, it will be on the balance that already grew with the interest that was added the prior month.
Therefore, compounding interest on a debt can add up quickly. The bank is charging you for the convenience of revolving the balance.
To see how compound interest is calculated differently from simple interest, just do a side-by-side comparison with the same terms. Here is what it would be for each method, on $4,000, with an annual interest rate of 8% over the course of four years.
Simple interest is calculated by multiplying the principal (P) by the rate (R) by time (T). This would be the calculation for the above example:
$4,000 x 0.08 x 4 = $1,280
So, in four years, the total interest would be $1,280 and the balance would grow to $5,280.
Compound interest is calculated by applying the interest to the principal as well as the accrued interest, after each year. Breaking it down:
Compared to the simple interest, the compound interest is $161.96 more.
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 on. This is the formula:
P x (1+r)t = Future value (FV)
In this formula, “P” represents 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 work backward, which is useful when you want to establish a goal of saving a specific amount of money in a fixed time period. In other words, if you know your target FV and would like to figure out your needed present value, you can work the formula backward:
P = FV ÷ (1+r)t
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 U.S. Securities and Exchange Commission.
When you want compounding interest to work in your favor because you are building funds for the future, keep the components of compounding interest in mind. For growing your money, you will want the following components.
The flip side of growing money, of course, is losing it. That’s easy to do when compounding interest is calculated on a debt. Again, keep the components of compounding interest in mind. This time, you will want the following components.
In the end, compounding interest is a powerful way to either 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 for your dreams, from starting your own business to retiring in luxury. And by calculating what you could lose by allowing a balance to accrue excessive interest, you can make better decisions when shopping and managing your accounts. The choice is yours.
Elaine J. Hom contributed to the writing and research in this article.