If you’ve ever heard the term “compound interest” and had no idea what it means, you’re not alone. You’ll be happy to know that it’s actually a simple concept. To put it VERY simply, it’s interest on interest.
If you’ve ever wondered how much interest you’re really earning on your account, check out the MU30 Compound Interest Calculator.
What’s Ahead:
Compound interest calculator
How to use the compound interest calculator
The Compound Interest Calculator can be used to provide you with two important pieces of information about your investment:
- The total value of your investment at the end of the investment term.
- How much interest you’ll earn over the full term of the investment.
And not only can the Calculator provide you with this information about a specific investment, but you can also use it to compare multiple investments to determine which will be the best one to choose.
The calculator requires that you enter six pieces of information:
- Initial investment – Enter the amount of money you are starting out with.
- Deposit amount – This is the number of periodic deposits you plan to add to your investment. Even if it won’t be a specific amount each time, use the average of what you expect to contribute over the life of the investment.
- Deposit basis – Enter the frequency of your periodic deposits. It can be yearly, semiannually, quarterly, or monthly. If you plan to make weekly deposits, just multiply the deposit amount by 4.333 and set the frequency to monthly.
- Interest rate – Enter the rate of return you expect on your investment over the entire term.
- Interest is compounded – Enter the frequency of compounding, which should be provided by the bank or other financial institution where your investment will be held. The Calculator gives you a choice between yearly, semi-annually, quarterly, monthly, and daily.
- Number of years – Use the slide bar to enter the number of years you’ll hold that particular investment. You can enter anywhere from one year to 35 years.
Once the required information has been entered, hit the “Calculate” button, and both the total value of your investment at the end of the term and the interest earned over the life of the investment will be displayed.
You can play around with the Calculator and run scenarios for different investments. For example, you can change the information entered on any of the six inputs, and see how that will affect the outcome of your investment.
What is compound interest?
The simplest description of compound interest is that it reflects not only interest earned on the principal amount of your investment, but also the interest earned on the accumulated interest in your investment.
The benefit of compound interest is that you’ll earn more interest on your investment through compounding than you will through simple interest. And unfortunately, you’ll also pay more in interest on loans you owe. Lenders almost always use compound interest in calculating loan payments.
Under a simple interest arrangement, you might invest $10,000 at a 5% rate of interest for one year. At the end of one year, you’ll receive $10,500 – $10,000 representing your original principal, plus $500 in interest earned.
Now, if you take the same investment but add monthly compounding to the arrangement, you’ll receive $10,511.62 at the end of one year. $10,000 will represent your original principal investment, $500 will be simple interest, and $11.62 will be the interest you earned on your simple interest. (Yes, I used the Compound Interest Calculator to calculate this investment!)
How does compound interest work?
Not surprisingly, the more frequent the compounding frequency, the higher the amount of interest you’ll earn on your investment. For example, I used monthly compounding in the example above. But if the compounding frequency is daily – which is common with bank investments – the interest earned would be even higher.
For that reason, you should always favor interest-bearing investments that compound with the greatest frequency. Daily is typically the best option, while annually will provide the lowest return.
In the example given above, I looked at the effect of compounding over one year. That’s a very simple example and one that doesn’t adequately demonstrate exactly what compounding of interest can do. So, let’s take a look at compounding over a longer-term.
You have two investments, Investment A and Investment B. The terms of each are as follows:
- Investment A: $10,000 invested at 5% for 20 years, compounded yearly.
- Investment B: $10,000 invested at 5% for 20 years, compounded daily.
At the end of 20 years, the investment returns look like this:
- Investment A: $26 532.98, comprised of $10,000 in original principal, and $16,532.98 in interest earned over 20 years.
- Investment B: $27,180.96, comprised of $10,000 in original principal, and $17,180.96 in interest earned over 20 years.
As you can see from this example, Investment B earned an extra $647.98 over 20 years, and the only thing I did differently was to choose an investment that compounds daily rather than yearly.
That makes it just about the easiest extra money you’ll ever earn in your life!
The “rule of 72”
This is a favorite rule of accountants, but it can also be a good tool for mere mortals. The Rule of 72 provides an approximation of how long it will take an investment to double in value based on a certain interest rate.
It works by dividing 72 by the rate of return on your investment.
For example, let’s say you invest $10,000 at 6%, and you want to know how long it will take to double your investment. By dividing 72 by 6%, you’ll get 12. That means it will take 12 years for the value of your investment to double at that rate of interest.
The Rule of 72 won’t help you with more complicated calculations, but getting the answer to “when will my investment double” is a very common question among investors. And if you ever have that question with an investment you’re considering or already own, you can use the rule to find the answer for yourself.
How to use compound interest to your advantage
Compound interest is one of your best friends on the investment side. But it’s also something of an enemy when you borrow money. That’s because it works the same in both directions, except that with an investment you’re on the receiving side of the interest equation. With a loan, you’re on the paying side, which means the interest will cost you more.
There are ways to play compound interest when it comes to both investments and loans.
To use compound interest to your advantage with investments:
- Choose investments that have the most frequent compounding possible; daily or continuously are the best choices.
- Invest as soon as possible; compounding of interest works best over longer terms.
- Let “APY” be your guide – that’s annual percentage yield, which reflects the interest you’re earning including compounding. It’s the best way to compare one interest-bearing investment with another.
To use compound interest to your advantage with loans:
- Pay close attention to “APR” – that’s the annual percentage rate on a loan. It reflects not only compounding of interest paid to the lender, but also any fees that you may pay in connection with obtaining or maintaining a loan. In the lending industry, flat interest rates, like 17.99% don’t matter nearly as much as an APR of 19.12%. The latter is the effective rate you’re really paying.
- Keep your loan terms as short as possible. Just as compound interest works to your advantage over longer terms with investing, it works against you when it comes to borrowing.
- Making additional principal payments won’t lower your APR, but it will reduce the amount of interest you’ll pay over the life of the loan, as well as the term of the loan.
Once you understand how compound interest works, you can make it your friend whether you’re investing or borrowing.
Summary
When you earn compound interest, you’re earning interest on your interest. So, if you have a high yield savings account that compounds interest daily, you’ll earn way more than someone who has a bank account that compounds interest daily.
Compound interest is just about the easiest way to have your money make money all on its own!
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