Compound Interest Illustrated!
The goal of compound interest is to make your money work hard for you. The alternative, of course, is to work hard for your money. Which would you prefer?
The gentleman shown above has his dollars working for him. This is not a new concept. In fact, you can find historical references to compound interest from around the world.
The key step in using compound interest is to actually start saving. You don't have to save a lot – just save what you can. Compound interest will do the rest of the work for you.
It's important to get a competitive rate (or APY) for compound interest to work for you. You don't need to earn the best rate on the planet, but you should earn a competitive rate. A good place to find rates and accounts on some online banking page of your favorite bank.
Our example lets you see what your savings will generate, with pictures and illustrations, so read on.
How Simple Interest Works on Your Money
By leaving your money in an account that grows it, you end up with a nice reward.
It's really easy to do this, you just have to get money in an account and keep it there. Then, let compound interest do its thing.
Compound interest is so fascinating that Albert Einstein referred to it as "magic" and called it "The most powerful force in the universe…". Remember, this was a guy who knew a thing or two about forces in the universe.
Simple interest is the most basic type of interest. In order to understand how various types of transactions work, it helps to have a complete understanding of simple interest. For example, you may pay interest on a loan, and it is important to understand how interest works. Better yet, your bank may be paying you interest on your deposits – and you can maximize your earnings by knowing more about interest.
Simple Interest Overview
Simple interest is just the amount of money paid on a loan. It is the easiest type of interest to calculate and understand. Other types of interest (like APY) can be more complex.
Simple Interest Formula
If you want to calculate simple interest, use this formula:
I=P r t
In other words Interest (I) is calculated by multiplying Principal (p) times the Rate (r) times the number of Time (t) periods.
For example, if I invest $100 (the Principal) at a 5% annual rate for 1 year the simple interest calculation is:
I=P r t
$5 = $100 x 5 % x 1 yr
Simple Interest Limitations
In fact, your interest – whether you’re paying it or earning it – is usually calculated using different methods. However, simple interest is a good start that gives us a general idea of what a loan will cost or what an investment will give us.
The main limitation that you should keep in mind is that simple interest does not take compounding into account. Simple Interest is a very Basic way of looking at interest.
Going Forward
Now that you know how simple interest works, you can look at more complex types of interest. Most of them are a variation of simple interest, and the calculations are repeated several times throughout the life of a loan.
A good next step is to familiarize yourself with Annual Percentage Yield (APY) which takes compounding into effect.
Compound Interest Illustrated.
Earn Interest on Your Savings
Because your money is in an account with a competitive rate, you'll earn interest payments on your initial deposit. Above, you'll see that the deposit (coin on top) earns interest (coins on the bottom).
To see how the interest is calculated at this point, read over the above information on simple interest.
Earn Interest on Your Interest
Let's assume that your bank pays interest every month. As each month goes by, you'll earn interest on everything in your account. Most importantly, you'll earn interest on previous interest payments.
Don't forget that your initial deposit will also earn interest each month. It earns interest over and over again. The second interest payment is highlighted in yellow.
Hopefully you're starting to see the power of compound interest.
Earn Even More Interest on Your Interest
You probably aren't surprised to see this. Your interest payments will continue to earn more and more interest. Plus, the initial deposit will kick the cycle off many more times.
Note that you could take some money out of your account and spend it. However, you'll lose out on more compounding. Let's take a look at what happens if you leave everything in the account.
The Magic of Compounding
By leaving your money in an account that grows it, you end up with a nice reward.
It's really easy to do this, you just have to get money in an account and keep it there. Then, let compound interest do its thing.
The Real Magic Of Compounding Interest
Compound interest is so fascinating that Albert Einstein referred to it as "magic" and called it "The most powerful force in the universe…".
Remember, this was a guy who knew a thing or two about forces in the universe.
Things You’ll Need to Use Formula :
Possibly a calculator
Principal amount invested
Rate of return
Number of years (you decide this)
Step 1:
FV = P(1 + r)n => this yields your formula for future value FV= Future Value P= Your Principal investment r= Your rate of return expressed as a decimal (5% expressed as 0.05) n= number of years you want to know(calculate as a power of)
Step 2:
Get your calculator (some calculators already have this formula; just plug in numbers) If not, you must first perform parenthesses calculation first (1+r) Ex: (1+0.05)= 1.05 So, your formula now looks like this FV=P(1.05)n
Step 3:
Next, put in your Principal amount. Let's say $1000 is your principal amount. Your formula now looks like this FV=1000(1.05)n We are almost done! Now put in the number of years. Let's say 10 years. So, FV=1000(1.05)10 and that is 1.05 to the tenth power.
Step 4:
Your calculator on your desktop will handle this quite well. Switch over to scientific mode. Put in 1.05 then press the x^y key and then enter 10. This will give you 1.62889462675(according to my accounting calculator) round to 1.63.
Step 5:
Now, FV=1000(1.63) and 1000 multiplied by 1.63= 1630. So, in 10 years you will have gained $630 in interest compounded.