What Is Compound Interest And How Is It Calculated?
June 29, 2023 7-minute read
Author: Ashley Kilroy
Buying or refinancing a home means comparing mortgage interest rates, and that means looking at how compound interest affects your financial circumstances. Compound interest is calculated based on the principal and already-existing interest from the previous period.
For loans, compound interest may happen when interest due is not paid and then added to the loan’s principle, which then builds upon itself, so repaying the loan takes more time. On the other hand, a savings account with compounding interest means your interest payments will turn into higher interest payments with each successive compounding period. This guide will discuss the definition of compound interest, teach you how to calculate compound interest, and show its benefits and disadvantages.
What Is Compound Interest?
Compound interest is calculated both on the original loan balance and from previously accumulated interest. For example, say you have $1,000 in the bank at a 3% interest rate that compounds monthly. This means that your account earns 3% interest annually, but the interest is added monthly to your account. And you receive interest on your interest. The first thing to do is take the annual interest rate and divide by the number of payments (12), which results in a monthly interest rate of 0.25%. After the first month, your interest rate will earn you $2.50, giving you a new balance of $1,002.50. At the end of the second month, compound interest means you’ll earn 0.25% interest on $1,002.50, which is $2.63. As a result, you’ll continue receiving higher interest payments as your balance grows.
Lenders apply compound interest to mortgages and other loans. Your savings account may earn compound interest on your behalf, and you’ll also pay compound interest on various loans. So, it’s vital to understand that the principal isn’t the only factor affecting a loan or bank account. Compounding interest means the balance incorporates past interest and grows more rapidly than other interest types.
Compound Interest Vs. Simple Interest
Simple interest is calculated solely on the original loan balance. Interest growth is slower because accrued interest won’t count toward future interest accumulation. Using the example above, the 3% interest rate will always use only the principle of $1,000 for simple interest payments.
In contrast, compound interest adds previous interest accrual to the balance. In other words, the interest rate multiplies by an increasingly higher balance from past interest. As a result, investments with compound interest rates are more lucrative.
How Does Compound Interest Work?
Compound interest applies an annual interest rate to the principal amount and the accrual of past interest payments. How often compounding occurs depends on the lender and the financial product. For example, your money market account might compound monthly, while a certificate of deposit (CD) might compound twice annually.
Compound interest means your return on investment from a savings account or other asset will help you receive larger returns in the future, compared to an account with simple interest. Specifically, your earned interest in a savings account will itself earn interest when your account compounds next.
Remember, compound interest works similarly for loans. A loan with a compounding interest rate will grow based on the principal plus interest charges. As a result, it’s vital to repay the loan as quickly as possible to minimize interest charges. Ignoring the loan or making minimum payments can create an insurmountable debt that continues to multiply by higher amounts.
How To Calculate Compound Interest
Calculating compound interest is simple with the compound interest formula:
Compound Interest Formula
B = P x (1 + R/N)(N x T)
Here’s the breakdown of this formula by each of its components:
- B:Ending balance
- P:Initial principal
- R: Annual interest rate
- N:Number of times each year that the interest on an investment or loan compounds
- T: Length of time you’ll have the investment or loan
Here are a couple of examples to show how this works.
Say you invest $4,000 in a certificate of deposit (CD) that pays 2% interest compounded semiannually (every 6 months) for 4 years. Your total return would be the following:
Compound Interest Calculation Example
$4,000 x (1 + .02/2)2x4
Ending balance: $4,331.43
In this case, when the CD matures, you’d have $4,331.43.
What if you’re trying to figure out how much interest you pay on a mortgage? You can use this formula to determine how much interest you would pay over the life of the loan by first calculating the total amount of money paid if you made every payment on time. Then you can subtract the initial principal balance to get the interest paid.
However, this method isn’t as straightforward because your monthly payments reduce the principal balance. So, taking a careful look at how mortgage amortization is calculated is crucial.
How Can You Tell If Interest Is Being Compounded?
If you want to confirm a balance has compound interest of an investment account or credit card, look at a recent statement. With compound interest, your interest rate will apply to the principal balance and previous interest accumulation.
Conversely, with simple interest, your principal balance will determine interest accrual. For example, a home equity line of credit uses a simple interest rate. If you have one, you should see your lender solely uses your principal to calculate interest accrual.
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What Are The Pros And Cons Of Compounding?
When investing or borrowing with compound interest, looking at the benefits and drawbacks is critical. Below are both sides to consider.
Here are the benefits of an account with compound interest.
- Build your savings faster. If you invest in a bond with compound interest, your investment will grow quicker than an asset with simple interest. You’ll earn returns on the money you’ve invested plus earnings from previous compounding periods. As a result, compound interest gives investments exponential growth.
- It’s free. Generally, financial institutions include compound interest on assets free of charge. You won’t need to pay an additional fee to apply compound interest to your account.
- Time is your benefit. Time is essential for compound interest to work because the earlier you add money to your investment, the more compounding periods will occur. Remember, your initial investment amount and interest rate determine how profitable compounding interest will be. So, the longer you keep adding money to your account, the more you’ll see down the road.
Although compound interest brings significant benefits, here are its disadvantages when investing.
- Fees are involved with investments. Although compound interest costs nothing, investing always has fees. For example, you might pay commissions, expense ratios, administrative fees, and more to invest in stocks and bonds. These fees will take away from your investment account and slow growth. In addition, most interest is taxable, so compound interest earnings will likely mean more taxation when you file.
- It can be financially harmful, especially when you’re paying compound interest instead of earning it. For instance, credit card debt with compounding interest can be financially ruinous because companies usually compound your interest daily.
- Patience is key. When investing with compound interest, time is your best friend. However, you won’t see huge returns immediately, and you need large amounts of money to reap significant benefits. As a result, compound interest requires time and discipline to be profitable.
How Can You Take Advantage Of Compound Interest?
Compound interest can take your finances to the next level. Here’s how to take advantage of this powerful tool.
Start Saving ASAP
Saving money now is the best way to make the most of compound interest. Acting sooner instead of later will give more time for compounding interest to take effect, earning you more money.
Pay Attention To The APY
When using compounding interest, it’s helpful to check a financial product’s annual percentage yield (APY). APY uses compounding interest in its calculation and can give you an accurate idea of how compounding interest will affect your money. Contrastingly, annual percentage rate (APR) uses simple interest but usually includes the fees and costs needed to qualify for a loan, such as mortgage closing costs.
Understand The Compounding Schedule
The compounding schedule is crucial because more frequent compounding means more interest accrual. In other words, your compounding schedule determines how often you earn interest payments. As a result, investments that compound more will earn more. For example, a CD that compounds biannually will earn less than one that compounds monthly (provided the interest rates are similar).
The Bottom Line
You earn compound interest on preexisting interest. The more frequently it compounds, the more money you’ll generate and add to the balance, meaning even higher interest payments in the future. Therefore, compound interest is advantageous for investments but costly for debts.
Several variables that impact the compound interest an investment or loan generates include initial principal balance, annual interest rate, and compounding frequency. The compounding interest formula can help you determine your return on investment or compare loan products to get the best deal.
To take advantage of how compound interest works, invest early and often. The more time you give your compounding interest assets, the more returns you’ll receive. On the other hand, it’s a good idea to pay off any debts with compound interest quickly because your interest can spiral out of control.
Compounding interest affects mortgage amortization, so being well-versed in this facet will give you a leg up in your home search. Read more to learn how to get the best mortgage rate and enter the homebuying process prepared.
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