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What is compound interest?
Compound interest is interest calculated on the initial principal and also on the interest accumulated from previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than “simple interest” — which is calculated only on the initial principal amount.
The rate at which compound interest grows depends on the frequency of compounding periods; the higher the number of compounding periods, the greater the compound interest.
Why was Einstein so excited?
While the “magic” of compounding has led to the infamous story of Albert Einstein calling it “the eighth wonder of the world”, compounding can also work against consumers who have loans that carry very high interest rates. Debt from credit cards with high interest rates (ex: store cards) are a perfect example.
A credit card balance of $20,000 carried at an interest rate of 20% (compounded monthly) would result in total compound interest of $4,388 over a one year period. To break it down even further, that’s $365 per month. Yikes!
On a positive note, the magic of compounding can work to your advantage when it comes to your investments, and can be a major factor in wealth creation. Exponential growth from compounding interest is also important in combating unavoidable expenses, such as; rises in the cost of living, inflation and reduction of purchasing power.
How do I calculate compound interest?
The formula for annual compound interest, including principal sum, is: A = P (1 + r/n) (nt)
Here’s an explanation for each variable in the equation:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed for
This can be pretty overwhelming for those of us who aren’t math whizzes, see below for a little bit of help.
Here’s an easy to use calculator
If you’re like me, math isn’t necessarily your strong suit. Which is why I was thrilled to find this awesome calculator, provided by MoneyChimp.com. It’s easy to use, even for those who are mathematically challenged! This tool will do all of the heavy lifting for you.