Using this calculator, you can estimate how much you will make from your deposit. You need to be able to anticipate the final result in order to make smart financial decisions. It is important to know how to calculate compound interest so that you are able to make smart financial decisions.
As you read on, you will find answers to the following questions:
- What is the definition of an interest rate?
- In what way does compound interest work? What is its formula?
- Is there a difference between simple and compound interest rates?
- Compound interest formula: what is it?
- What is the frequency of compounding?
Using our student loan calculator, you can track your expenses and compare different options for student loans.
The definition of interest rates
Interest rates are charged by lenders to borrowers to cover the cost of borrowing, while lenders charge interest rates to borrowers to cover the cost of using their assets.
From a financial perspective, when you deposit money in a bank (e.g., save money), you have lent money to the bank, which explains the interest rate.
Interest rates are usually expressed as a percent of the principal amount (outstanding loan or value of deposit). They are usually expressed annually as annual percentage yields (APYs) or effective annual rates (EARs).
How is compound interest defined?
A compound interest account earns interest not only on the initial investment, but also on all subsequent interest that is earned. In other words, compound interest is the interest on both the initial principal and the interest accrued on this principle so far. The fundamental feature of compound interest is that interest itself earns interest. By adding a carrying charge, a deposit or loan grows at a faster rate.
Using the compound interest equation, you can figure out what an investment is worth after a certain period or calculate how much you have earned from buying and selling. You can also use it to figure out how long it will take you to double your investment, for example.
Below are examples of how we will answer these questions.
Compound interest vs. simple interest
Compound interest, on the other hand, consists of the interest on the initial principal plus the interest which has been accumulated in the meantime. Money’s initial sum is the only thing used to calculate simple interest.
Frequency of compounding
You will be told by most financial advisors that compounding frequency refers to how often interest is added to principal in a year. This definition will be meaningless if you don’t understand compounding… To understand this term, you need to know that compounding frequency is an answer to the question: How often is interest added to the principal? Compounding frequency means that the interest will be calculated on top of the original amount after a certain period of time.
Here are some examples:
- There is one compounding frequency for annual (1/Yr) compounding,
- The quarterly compounding frequency is four per year,
- Compounded monthly (12/Yr) has a compounding frequency of twelve.
In general, the higher the compounding frequency is, the greater the final balance. However, even the highest frequency cannot exceed a certain limit. For more information, use our natural logarithm calculator.
Due to the calculator’s emphasis on compounding, we designed a chart that shows the progress of the annual interest balances visually. Diagrams will show the extra or additional interest that has been gained over yearly compounding if you choose a higher compounding frequency. As a result, you will be able to observe compounding’s real power in this way.
Formula for compound interest
With the compound interest formula, you can estimate how much your savings account will earn. Due to the fact that it takes into account not only the interest rate and the number of years, but also how many times the interest is compounded each year, it is quite complex.
Using the following formula, we can calculate annual compound interest:
FV = P (1+ r/m)^mt
- We use FV as the final balance in our calculator, which indicates the investment’s future value
- P – Investment value (the initial balance)
- r – Rate of interest for the year (decimal)
- m – frequency of compounding ( compounding frequency)
- t – Duration of investment
The interest rate ( r ) is called CAGR (compound annual growth rate) when the compounding period is one (m = 1).