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What is compound interest, and how to calculate it?

What is compound interest, and how to calculate it?

In a low-interest rate environment, growing your money can be challenging. One way to grow your money is to take advantage of compound interest. So the sooner you start your savings, the more you could grow them with compounding.

Banks use interest rates as a way to attract customers to open savings accounts and term deposits. Generally, the higher the rate of interest, the more your money will grow. Financial institutions calculate the interest either as simple or compound interest.

What is simple interest vs. compound interest?

Simple interest offers a fixed rate over a set period. For example, if you invest $5000 at 1 per cent interest for one year, you’ll receive $50 in interest at the end of one year.

On the other hand, compound interest pays interest over the interest already earned on your savings. Most term deposits and savings accounts provide compound interest. You don’t need to wait for the end of the term to receive the interest. You can choose to receive it daily, weekly, monthly, or quarterly, depending on the type of account. This means your savings grow faster when the interest is compounded.

How to calculate compound interest

A simple way to calculate compound interest is to use the following formula:

A = P * (1+r) ^n

Where:

  • A = ending amount
  • P = principal
  • R = rate of interest
  • N = number of periods

To calculate monthly compound interest on a savings account, divide the rate of interest by 12 and replace N with the number of months during which you are investing.

Here is an example to help you understand. Assume that you invest $10,000 for two years at the rate of five per cent per annum, and the interest is compounded monthly. Using the above formula, the closing balance after two years is:

A = $10,000 * (1+0.0042) ^ 24 = $11,049.41

You need to divide the annual five per cent interest by 12 as interest is compounded monthly. Additionally, the number of periods is 24 months as the investment horizon is two years.

How to increase savings using compound interest?

In low-interest rate situations, your savings may grow only in line with inflation. But you can increase your savings by regularly adding money to your account when affordable. As the deposit amount grows, the higher the interest paid. With a disciplined and diligent savings plan, you can grow your money over the long term.

What should you know when calculating compound interest?

  1. Firstly, you need to know the initial deposit amount, which is also called the principal. This is the amount on which interest is calculated.
  2. Next, the interest depends on the investment period. The longer the period, the more the interest paid.
  3. Another factor that determines your return is the rate of interest, which is generally the standard annual rate. Don’t confuse the rate with a bonus or introductory rate of interest you may receive when opening the account.
  4. You’ll need to check the frequency of interest calculation, whether it is daily, monthly, or annually. Generally, your money will grow more quickly if the interest is paid more frequently.
  5. Finally, the interest depends on how often you deposit money into your savings account. For example, if you receive extra funds via a Christmas gift or bonus, depositing the money into your account will help you earn more interest.

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This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.

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