Compound interest or compounding interest refers to the phenomenon where the interest associated with a bank account, investment, or loan increases exponentially or rather than linearly over time. The word “compound” is the keyword to understand. In this article, we will discuss compound interest in detail with their pros and cons. Read along.
Suppose that you made a $100 investment in a business that pays you a dividend of 10% each year. Now, you have the option that you can pocket those dividend 10% payments like reinvesting or cash those payments into additional shares. If you have chosen the option second which is reinvesting the 10% dividends and compounding them together with your current initial $100 investment then the returns you have made will start to grow over time.
It is the interest on a deposit or loan that is calculated based on the initial principal and the accumulated interest both from interest accrues that depends on the frequency of compounding, it simply means that the higher the number of compounding periods, the greater the compound interest. So, let’s read in detail about compound interest.
How Does Compound Interest Work?
Compound interest or compounding interest is simply calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The total initial amount of the loan is then subtracted from the resulting value. The well-known formula for calculating the compound interest is:
=[P ( 1 + i)^n] – P
=P[ (1 + i)^n – 1]
Here, p stands for principal, I stands for the nominal annual interest rate in percentage terms and n is simply for the number of compounding periods. To calculate the compound interest let’s take a simple example: suppose that a three-year loan of $10,000 at a 5% interest rate that compounds annually. Then the compound interest would be like:
$10,000[ (1+0.05)^3 – 1] = $10,000
[1,157625 – 1] = $1,576.25.
How does compound interest grow?
Now, it is important to know how compound interest grows. So, because compound interest includes the accumulated interest in previous periods, it grows at an ever-accelerating rate. Just like in the above example, the total interest payable throughout the three-year-long period of this loan is $1,576.25 and the amount of interest rate is not the same for all three years because it would be with simple interest.
Compound interest or compounding interest can significantly boost your investment returns over the long term. While a $100,000 deposit that usually receives 5% simple annual interest would earn $50,000 in total interest over the 10 years so the annual compound interest of 5% on $10,000 would be the amount to $62,889.46 over the same period. If the same compounding period were instead paid monthly over the same duration of ten years at 5% compound interest then the total interest would instead grow to this amount of $64,700.95.1. Now, let’s discuss the pros and cons of compounding interest.
Pros and Cons of Compounding interest.
Yes! Compounding interest has pros as well as cons too. Though the miracle of compounding interest has led to the apocryphal story of the genius Albert Einstein calling it the eighth wonder of the world or man’s greatest invention. Remember, compounding interest can also work against the consumers who have loans that have very high interest rates, like credit card debt. Normally, A credit card balance of $20,000 carried at an interest rate of 20% compounded monthly would result in a total compound interest of $4,388 over one year or about $365 per month.
And if we talk about pros then compounding interest can work to your benefit when it comes to your investments and it also can be a potent factor in wealth creation. Remember, Exponential growth from compounding interest is also important in mitigating wealth-eroding factors, like increases in the cost of inflation, living, and reduced purchasing power.
The well-known Mutual fund’s offers are one of the easiest ways for investors to get the advantages of compound interest. Choosing the option to reinvest dividends derived from the mutual fund results in purchasing more shares of the fund. More compound interest accumulates over time, and then the cycle of purchasing more shares will continue to help the investment in the fund grow in value.
Considering, a mutual fund investment that opened with an initial $5,000 and an annual addition of $2,400. With an average annual return of 12% over the 30 years, the future value of the fund amount is $798,500. The compound interest is simply the difference between the cash contributed to the investment and the actual future value of the investment. In this case, by contributing the amount $77,000, or a cumulative contribution of just $200 per month, over the time of 30 years, compound interest is $721,500 of the future balance.
Remember, earnings from the compound interest are taxable unless the amount of money is in a tax-sheltered account; it’s ordinarily taxed at the standard rate associated with the taxpayer’s tax bracket. Just read along to know more.
How to calculate compound interest?
If you don’t know how to calculate compound interest then here we are going to discuss those three ways and by using those ways you can easily calculate the compound interest. Many calculators both handheld and computer-based hash functions, can be utilized for such purposes. Now, let’s get to know those three ways. Remember, here we calculate the compound interest in Microsoft excel.
The first and easiest way to calculate compound interest is to multiply every year’s new balance by the percent of interest rate. Suppose, you deposit $1,000 into your savings account with an interest rate of 5% that compounds annually and now you want to calculate the balance you have in five years. so, Just take your device, go to Microsoft Excel, enter “Year” into the respective cell A1 and “Balance” into B1 cell.
After that, Enter years 0 to 5 into the respective cells A2 through A7. The balance for year 0 is $1,000, so now you would enter “1000” into cell B2. Next, enter “=B2*1.05” into cell B3. Then enter “=B3*1.05” into cell B4 and continue to do this until you get to cell B7. In cell B7, the calculation is “=B6*1.05”. Finally, the calculated value in cell B7 is $1,276.28 and it is the balance in your savings account after five years. To find the compound interest value, subtract $1,000 from $1,276.28; this gives you a value of $276.28.
The second trick to calculate compound interest is to use a fixed formula. The
compound interest formula is ((P*(1+i)^n) – P), where P is the principal, i is the annual interest rate, and n is the number of periods. Using the same information above, enter “Principal value” into cell A1 and 1000 into cell B1. Next, enter “Interest rate” into cell A2 and “.05” into cell B2. Enter “Compound periods” into cell A3 and “5” into cell B3. Now you can easily calculate the compound interest in cell B4 by entering “=(B1*(1+B2)^B3)-B1”, which gives you $276.28.
A third and the last trick to calculate compound interest is to create a simple macro function. First start the Visual Basic Editor in your device, which is located in the developer tab. Click the Insert menu, and click on Module. Then type “Function Compound_Interest (P As Double, I As Double, N As Double) As Double” in the first line. On the second line, hit the tab key and type in “Compound_Interest = (P*(1+i)^n) – P.” On the third line of the module, enter “End Function.”
Here, You have created a function macro to calculate the compound interest rate. Continuing from the same Excel worksheet above, enter “Compound interest” into cell A6 and enter “=Compound_Interest(B1, B2, B3).” This gives you a value of $276.28, which is consistent with the first two values.
In the above article I have discussed how to calculate compound interest, what is the basic formula of it with the pros and cons of compound interest. The tricks I have discussed above are the easiest tricks to calculate the compound interest. Hope you get help from the article. Thanks for reading. Don’t know about the strategies on how to do investments to know about investments just read along with this article.