Compound Interest Basics

Have you ever wanted to maximize your money but felt too confused, intimidated, or overwhelmed by financial terms and formulas? While it might seem difficult, understanding how to use compound interest to grow your savings and minimize your loan debt are essential ways to take control of your financial security.

Key Terms

• Starting principle is the initial amount of money that is placed in a savings account or obtained through a loan.

  -How much money did I start with in this account?

• Interest is an additional amount of money that you either earn or are charged based on the interest rate over a period of time. For a savings account, you earn interest. For a loan, you are charged interest. A higher interest rate will cause a higher amount that is earned or charged.

  -I want a high interest rate for savings and a low interest rate for loans.

• Simple interest is interest calculated only on the starting principle.

  -If I have $1000 in my savings account with an annual interest rate of 1%, I will earn $10 in Year 1 and $10 each year afterwards.

• Compound interest is interest calculated on the starting principle and all previous interest. Simply put, the interest is used to generate more interest.

  -If I have $1000 in my savings account with an annual interest rate of 1%, I will earn $10 in Year 1. In Year 2, I will earn $10.10.

Compound interest is a powerful tool in controlling your finances.

If you have heard stories of people needing years to pay off their loan debt because their original debt increases every year, you are already familiar with the concept of compound interest. Over time, compound interest grows at an ever-increasing rate. This makes paying off debts harder because it increases the amount of money owed.

In contrast, compound interest within a savings account is great way to grow money with little effort. Plant the seed with the initial deposit, and watch it grow!

The formula to calculate compound interest is far more complex than simple interest so don't be frightened if it looks like a foreign language at first! While it is not necessary to always calculate compound interest by hand (that's why web-driven interest calculators exist!), it is important to understand the factors that can impact the number you will be billed or given each year.

Compound Interest Formula

P (1 + [r / n]) ^ nt = A

• P = the principal amount

• r = the annual rate of interest

• n = the number of times the interest is compounded per year

• t = the time, or number of years, the amount has been deposited or will be billed

• A = the total amount of money generated, including interest

Let's Practice!

• $5,000 is put in a savings account paying 2% interest which is compounded monthly for 20 years.

  • Based off the above, P = $5,000, r =.02, n = 12, and t = 20.

  • P (1 + [r / n]) ^ nt = A

  • $5,000 (1 + [.02 / 12]) ^(12x20) = A

  • $5,000 (1 + .001667)^ (240) = A

  • $5,000 (1.491447)

  • A = $7457.24

In addition to the original deposit of $5,000, you would have generated $2,457.24 in interest over 20 years, for a total of $7457.24. Not a bad chunk of change!

Compound interest is a complex, but necessary tool to maximize your money's growth and minimize things that will drain your hard earned finances. When confused, remember these quick tips:

• A high interest rate is desired for savings and a low interest rate is desired for loans. This is especially true when the interest is compounded interest.

• Try to pay off loan debt as quickly as possible to prevent it from multiplied growth.

• Try to place extra money in savings accounts with compound interest to encourage multiplied growth.

Incorporate these tips into your daily life, and you are well on your way to becoming a finance extraordinaire!

Photo by Morning Brew on Unsplash