Compound Interest: Everything You Need to Know
Compound interest (or compounding interest) is one of the most important forces to manage your personal finances. Why? It can help or hurt you. For example, compounding interest can help you earn a higher return on your investments. On the other hand, it can increase your debt when you have interest compounding on loans. If we’ve piqued your interest, keep reading to learn more about compound interest.
What Is Compound Interest?
Compound interest is the addition of interest to the principal sum of a loan or deposit. Simply put, it is interest on your interest. As a result, the sum of an investment or loan grows quickly. For example:
- Year 1: Invest $10,000 and earn 10% interest = $1000 interest
- Year 2: Invest $11,000 and earn 10% interest = $1100 interest
- Year 3: Invest $12,100 and earn 10% interest = $1210 interest
As you can see, you can continually earn money even if you don’t make any deposits. The opposite is true of loans. Your loan balance can increase over time even if you don’t take out additional loans.
The frequency of compound interest can vary from daily to annually. The greater the frequency, the greater the return. Let’s take a look at $20,000 at 8% interest compounded at varying frequencies.
Calculating Compounding Interest
You can use the following formula to calculate compound interest:
A = P(1+[r/n])^nt
- A: amount
- P: principal
- r: interest rate
- n: number of compounding periods per year
- t: time
Let’s calculate a few problems.
- $100 invested monthly; interest compounded monthly; 40 years; 8% growth
- A = 100(1+[.08/12])^12*40
- A = $351,528.12
- $500 invested monthly; interest compounded semiannually; 10 years; 3% growth
- A = 500(1+[.03/2])^2*10
- A = $70,044.43
Compounding Interest and Benjamin Franklin
Benjamin Franklin is known for many accomplishments, such as being one of America’s Founding Fathers, a writer, an inventor, and more. But did you know he was interested in finance, specifically compounding interest? When Franklin died, he left $4,400 to his two favorite cities, Philadelphia and Boston. He requested the money be placed in a trust untouched but invested for 100 years. At 100 years, nearly 75% of the trust was used to fund civic projects and help tradesmen. The remaining balance was reinvested for another 100 years. By 1990, the combined balances for Philadelphia and Boston were an astounding $6.5 million.