Compound interest, also known as accumulated interest, is the most common type of earnings on investments or savings accounts. Compound interest is a sum of money or principal that earns interest. As each period of time progresses, interest is earned on both the principal and the accumulated interest from previous periods. This results in a greater amount of money at the end of the term than if interest were loaded only on the principal amount.
To calculate the value, or final value, of the investment with compound interest, one can use the compound interest formula. This formula is more often used when discussing investments in stocks, bonds, or other financial instruments that earn interest over a longer period of time.
The formula is as follows:
Final Value (V) = Principle (P) x (1 + Interest Rate (R)) ^ Number of Periods (N)
The first part of the equation, P x (1 + R), is the amount that the principal amount of money grows each period. The second part of the equation,^N, determines how many times the P x (1 + R) equation is multiplied by itself.
For example, if an investor deposits $500 into a savings account that earns 5% interest annually, the equation would be as follows:
V = 500 x (1 + 0.05)^10
V = $762.90
This equation yields a final value of $762.90. This is the amount of money the investor would have in the account after 10 years, based on a 5% annual interest rate.
Another example of a compound interest calculation can be found when investing in stock market funds. If an investor deposits $1,000 into a mutual fund that earns 8% interest annually, the equation would be as follows:
V = 1,000 x (1 + 0.08)^5
V = $1,489.16
The compounded value of the investor’s account in this example would be $1,489.16 after 5 years. Note that in this example, the investor has earned nearly $500 more on their deposit than if the interest had been earned only on the initial deposit amount of $1,000.
Compound interest is an effective way to grow wealth over time, and can yield much higher returns than simple interest on investments. Compound interest is also important when considering loan payments, as most types of loans have compound interest associated with them. It’s important to understand compound interest, as it plays a major role in achieving a variety of financial goals.
