What is compound interest? It is the “interest which is calculated not only on the initial principal, but also the accumulated interest of prior periods.” We hear about compound interest for more elaborate debts, unlike personal debts, school loans or simple interest on savings accounts for which simple interest is commonly used. The concept of compound interest is so powerful that it involves millions of people all over the world—such that when the compound interests are added, billions of dollars are involved over a period of time.
Most of us believe that the $25 that is spent at the moment is really worth $25—most people in the financing industry would say otherwise, because they say we are overlooking the fact about opportunity cost. If we do not spend the $25 today and we choose to invest it or save it, it may be worth more than double or triple in future, depending on the time frame and rate of interest we invest the $25 on.
How then do we calculate compound interest? Here is a formula, which at the same time show how the $25 saved or invested today will be worth in future.
Compound Interest Formula
FV = PV (1+i)^n
FV= future value
PV= present value
i= interest rate
n= number of years
Let us assume that your $25 earned a 9% annual return (the average between long term bond yields and historical small cap stock returns) over the period of 25 years. Let us now fit in the numbers into the compound interest formula:
FV = $25 (1.085)^25
The FV (future value) is equal to $215, which has grown to about 9 times its original value when treated as an investment instead of an expense. Even if the return is reduced to $107 if you take inflation into consideration, it is still more than 4 times the amount that you started with, at $25.
Another way to explain compound interest is that where the amount of interest earned during the first period, which is calculated initially as a simple interest, is added to the principal amount. The total amount then becomes the principal, and interest is again calculated for the second period, and the process is repeated. This is called compounding. A good example of compound interest is placing your money in a bank for a certain period of time. Calculation is done either quarterly, twice a year, or annually, depending on your agreement.
While banks calculate interest either quarterly, twice a year or annually, you will be surprised with how it is done by credit card companies—they calculate very often, not only monthly, but sometimes even daily.
If you know how to invest your money properly, you will never fail. Be a smart investor, by start investing at an early age, even with small amounts. Compound interest does not apply only to huge amounts of money, they also apply to small amounts of money.
It is now easy to calculate compound interest. Just go online, and voila, you will find lots of websites offering compound interest calculators for whatever purpose it may suit you, whether for real estate, banking purpose or even academic purpose.