Compound Interest Calculator
Understanding Compound Interest
Compound interest is often referred to as "interest on interest." It's a powerful concept in finance that allows your money to grow exponentially over time. Unlike simple interest, where interest is only calculated on the initial principal amount, compound interest calculates interest on the principal plus any accumulated interest from previous periods.
How Compound Interest Works:
Imagine you deposit $1,000 into a savings account with a 5% annual interest rate, compounded annually. After the first year, you'll earn $50 in interest ($1,000 * 0.05), bringing your total to $1,050. In the second year, you'll earn interest not just on the original $1,000, but on the entire $1,050. This means you'll earn $52.50 in interest ($1,050 * 0.05), and your new balance will be $1,102.50. This process repeats, with your earnings growing faster each period.
The Formula:
The formula for compound interest is:
A = P (1 + r/n)^(nt)
- 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 (as a decimal)
- n = the number of times that interest is compounded per year
- t = the number of years the money is invested or borrowed for
Why It Matters:
Understanding and utilizing compound interest is crucial for wealth building. Whether you're saving for retirement, investing in stocks, or even considering a loan, the effects of compounding can significantly impact your financial outcomes. The earlier you start investing and the longer your money has to grow, the more substantial the impact of compounding will be.
Example Calculation:
Let's say you invest $5,000 (Principal) at an annual interest rate of 7% (Annual Rate) for 20 years (Time), compounded quarterly (Compounding Frequency = 4).
- P = 5000
- r = 0.07 (7% as a decimal)
- n = 4 (quarterly compounding)
- t = 20
Using the formula: A = 5000 * (1 + 0.07/4)^(4*20) = 5000 * (1 + 0.0175)^80 = 5000 * (1.0175)^80 ≈ 5000 * 3.9398 ≈ $19,699.08
This means your initial $5,000 investment could grow to approximately $19,699.08 over 20 years, demonstrating the power of compounding.