Learn about compound interest, how it is calculated and how it can grow your savings over time. Understand the distinction between simple and compound interest, grasp the essential formula, and recognize the importance of starting investing early.
What is Compound Interest? How to Calculate
What is Compound Interest and How do you Calculate it?
So, you’ve probably heard the term “compound interest” thrown around, especially if you’ve ever looked into saving money or making investments. Today, we’re going to learn about this concept.
Now, imagine this. You save $100 in a magical jar, and at the end of the year, the jar gives you an extra $5 as a thank you. So, you decide to leave that $105 in the jar for another year. This time, the jar gives you a thank you not just for the initial $100, but also for the extra $5. That’s the basic idea behind compound interest – it’s interest on interest.
But let’s break it down a bit. There are two types of interest: simple and compound. Simple interest is calculated only on the principal amount, or on that portion of the principal amount which remains. It doesn’t take into account previously accrued interest. On the other hand, compound interest is calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan.
Here’s a fun fact. Did you know that if you start with just $1,000 and let it grow with compound interest at a rate of 5% annually, in 10 years, without adding anything extra, it would grow to over $1,600? That’s the magic of compounding. Your money starts to grow on its own, even without any additional contributions. The longer you let it sit and compound, the faster it grows!
But, you might ask, how often is this interest added? Great question! Interest can compound on any given frequency – daily, monthly, yearly, or even multiple times a day. The more frequent, the better the returns, thanks to our buddy, compound interest.
Here’s a step-by-step walkthrough of how it works:
– In the first year, you start with $1,000. Over the year, you earn 5% of that ($50) as interest. By the end of the year, you have $1,050.
– In the second year, you start with the $1,050 from the end of the first year. This year, you earn 5% interest on that $1,050, which comes out to $52.50. Add that to your starting amount and by the end of the second year, you have $1,102.50.
– This pattern continues for each year. Every year, the interest is calculated on the total amount (principal + previously earned interest) from the end of the previous year, not just the original $1,000.
By the tenth year, your initial $1,000 has grown to $1,628.89 due to the power of compound interest. The table visually demonstrates the snowball effect of compounding: as the years go by, not only does your initial investment earn interest, but the interest from previous years earns its own interest, leading to an exponential increase over time. This is why understanding compound interest is so crucial for long-term financial planning.
More simply, we can also use a formula. the formula for compound interest is A = P(1 + r/n)^(nt). Let’s unpack that. A stands for the future value of your investment. P is your principal amount – that’s the initial sum you’re starting with. r is your annual interest rate, n is how often your interest is compounded each year, and t is the time in years.
Compound Interest Formula
Let’s look at our example from before to make this crystal clear. Imagine you invest $1,000 at an annual interest rate of 5%, and it’s compounded annually. How much would that investment grow to in 10 years?
Let’s plug the numbers into the compound interest formula:
A = P(1 + r/n)^{nt}
Where:
P is the principal amount (initial investment) = $1,000
r is the annual interest rate (as a decimal) = 5% or 0.05
n is the number of times the interest is compounded per year = 1 (since it’s compounded annually)
t is the time the money is invested for in years
Given the example where you invest $1,000 at an annual interest rate of 5% compounded annually for 10 years:
A = 1000(1 + 0.05)^{1 \times 10}
A = 1000(1.05)^{10}
A = approx $1,628.89
When you plug in the numbers, after 10 years, your investment swells to approximately $1,628.89. That’s an impressive $628.89 more than your initial sum! Again, the beauty of compound interest is that each year, you’re earning interest not just on your original $1,000, but on all the accumulated interest from previous years.
Now, here’s something super important for the young folks out there. The earlier you start saving and investing, the more time your money has to compound. Even if you can’t invest a lot right now, starting early gives compound interest more time to work its magic. And that, my friends, can make a huge difference in the long run.
Finally, remember that compound interest can be both your best friend and your worst enemy. When you’re saving or investing, it’s your ally, helping your money grow. But, if you have debts or loans that compound, it can stack up pretty quickly. So, always be aware and make it work in your favor.
Lesson Resource
- What is Compound Interest Lesson – Teaching lesson plan for this lesson.
Money Instructor does not provide tax, legal, or investment advice. This material has been prepared for educational and informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or investment advice. You should consult your own tax, legal, and investment advisors regarding your own financial situation. Although the information has been researched and vetted beforehand, it may not be current at the time of viewing. Please note, the context of financial investments can be complex and dynamic, necessitating professional advice tailored to your unique circumstances.
