How do I use the compound interest calculator?
The compound interest calculator above will tell you the interest you will earn from an investment. All you have to do is input the investment amount, the length of time (or compounding period), and a hypothetical compound interest rate.
What is compounding?
Compounding is a financial term that refers to an asset increasing in value due to interest it earns on both the principal asset amount and the interest it has earned.
Most people encounter compounding when dealing with interest rates. Interest refers to the payments made for using money, which can apply to loans, bank accounts, credit cards, and other financial vehicles. You can calculate interest as a rate of the total money you invest or borrow.
Compound interest can help you build wealth over time. For instance, people with high-yield savings accounts will earn money from interest payments.
Compound interest rates are essential to understand. They can impact the total interest you earn from an investment. Compound interest rates are better for the investor because the interest payments will increase over time.
How is a compound interest different from a simple interest?
Interest payments come in two forms, compound and simple.
Simple interest is easy to understand and calculate. Simple interest payments are a percentage of the base amount of money. The interest payments are the same for the life of the investment.
Compound interest includes the simple interest payments plus interest payments you earn from before. Compound interest payments will increase over time. Investors prefer compound interest payments as compound interest yields more returns over time.
What’s an example of compound interest?
Let’s look at an example. For instance, imagine you take out a 3-year bond for $2,000 with a 3%.
Your simple interest payments in Year 1, Year 2, and Year 3 will be 3% of $2,000, or $60 each year. Thus, the total interest you earn on the 3-year bond with simple interest will be $180
Your compound interest payment will only be the same in Year 1, $60.
- For Year 2, you must calculate 3% of the bond amount ($2,000) plus any interest earned ($60). Thus, 3% of $2,060 is $61.80.
- For Year 3, you must take 3% of the bond amount ($2,000), plus any interest earned in Years 1 & 2 ($60; $61.80). Thus, 3% of $2,121.80 is $63.65
- Thus, the total interest earned on the 3-year loan with compound interest will be $185.45.
Where is compound interest used?
The most common place to encounter compound interest is at your bank.
Compound interest can be a positive thing for your savings and checking accounts. When the money in your bank accounts earns compound interest, the bank deposits those interest payments into your account. The bank is paying back interest payments to store your money with them.
Compound interest can also be positive when referring to your 401(k) and investment accounts. Like your bank accounts, these investment accounts will gain interest payments over time. As your account balance increases, the interest you earn will increase as well.
It’s essential to understand the downsides of compound interest when borrowing money. This can include student loans, mortgages, and other personal loans. In these situations, compound interest is unavoidable. Financial advisors suggest paying more than the recommended monthly payments. This will decrease the total amount of interest paid during the life of the loan.
Which compound interest rate is best?
Depending on the type of asset, you will want the highest or lowest compound interest rate available.
You will want the highest compound interest rate for your assets and money. This can include savings, checking, investment, 401(k) accounts, and dividends.
As an investor, you should shop for the highest interest rates possible. Different investment vehicles will offer different interest rates. In general, you will want to:
- Choose the highest interest rate. You should always ask this question.
- Choose an interest rate that has a high compound frequency.
- Invest as much as possible. The larger the investment, the more interest you will earn.
You will want the lowest compound interest rate for loans and money you borrow. This can include student loans, personal loans, mortgages, and credit cards.
Compound interest loans are unavoidable for a borrower. But you can lower the total interest amount in a few ways:
- Start with the lowest loan amount possible. The lower the principal amount, the lower the interest payments.
- Shorter loan lengths are always better. The less time you spend paying off the loan, the less interest you owe.
- Understand the frequency of compounding. Some loans compound every week, month, or year. The slower the pace of compounding, the better.