Compound interest differs from simple interest in that interest is charged on both the initial investment (principal) and interest already accrued, rather than just the principal.
Because of this, compound interest accounts grow faster than simple interest accounts. For example, if your interest is compounded annually, this means that you will earn more interest in the second year after investing than in the first year. Also, the value will grow even faster if interest is accrued several times a year.
Compound interest is offered on a variety of investment products and is also charged on certain types of loans, such as credit card debt. Calculate how much the amount will grow with compound interest, simply by using the right equations.
Step 1: Finding Annual Compound Interest
Determine the annual interest rate. The interest rate shown in your investment brochure or loan agreement is annual. If your car loan, for example, is a 6% loan, you pay 6% per annum. Calculating compound interest once at the end of the year is the simplest calculation of compound interest.
- Debt can accrue interest annually, monthly, or even daily.
- The more often your debt worsens, the faster interest will accrue.
- Compound interest can be viewed from both an investor’s and a debtor’s perspective. Frequent compounding means that the investor’s interest income will grow at a faster rate. It also means that the debtor will pay more interest until the debt is repaid.
- For example, a savings account may accumulate annually, while a payday loan may accumulate monthly or even weekly.
Step 2: Calculate the interest accrued annually for the first year.
Let’s say you own a $1,000 6% savings bond issued by the US Treasury. Treasury savings bonds pay interest each year based on their current interest rate and value.
- The interest paid in the first year will be $60 ($1,000 times 6% = $60).
- To calculate the interest for the second year, you must add the original principal amount to all interest received to date. In this case, the principal for year 2 would be ($1,000 + $60 = $1,060). The value of the bond is now $1,060, and the interest payment will be calculated based on that value.
Step 3: Calculate the interest capitalization for subsequent years.
To see the greatest impact of compound interest, calculate the interest for subsequent years. As you go year after year, the principal amount continues to grow.
- Multiply the principal amount of the second year by the interest rate on the bond. ($1,060 X 6% = $63.60). Interest received is $3.60 higher ($63.60-$60.00). This is because the principal has increased from $1,000 to $1,060.
- For year 3, the principal amount is ($1,060 + $63.60 = $1,123.60). Interest earned in the third year is $67.42. This amount is added to the main balance to calculate the 4th year.
- The longer the debt remains outstanding, the stronger the effect of compound interest. Outstanding means that the debtor is still in debt.
- Without compound interest, year 2 interest would be simple ($1,000 X 6% = $60). In fact, the interest earned each year would be $60 if it paid compound interest. This is known as simple interest.
Step 4: Create an Excel document to calculate compound interest.
It can be helpful to visualize compound interest by creating a simple model in Excel that shows the growth of your investment. To get started, open a document and label the top cell in columns A, B, and C “Year”, “Cost” and “Interest Earned” respectively.
- Enter years (0-5) in cells A2 through A7.
- Enter your principal in cell B2. For example, imagine you start with $1,000. Enter 1000.
- In cell B3, type “=B2*1.06” and press Enter. This means that your interest is compounded annually at a rate of 6% (0.06).
- Click in the lower right corner of cell B3 and drag the formula to cell B7. The numbers will be filled in accordingly.
- Put 0 in cell C2. In cell C3, type “=B3-B$2” and press Enter. This should give you the difference between the values in cells
- B3 and B2, which is the interest earned. Click in the lower right corner of cell C3 and drag the formula to cell C7. The values will populate by themselves.
- Continue this process to reproduce it for as many years as you want to track. You can also easily change the principal and interest rates by changing the formulas used and the contents of the cells.