Compound interest can be termed as the interest on a deposit or loan which is calculated based on accumulated interests from earlier periods and the initial principal amount. Originated originally in Italy in the 17th century, compound interest can be easily defined as interest levied on interest.
With the power of this mathematical calculation, you can make your capital sum grow at an exceptionally faster rate, unlike the formula of simple interest, which is completely dependent on the value of your principal amount of capital. One may want to use a compound interest calculator to make the process of this calculation much faster and simpler.
It accrues at a specific rate that is dependent on the frequency of compounding. In simple words, the higher the figure of compounding periods you have in your investment, the greater will be the interest compounded on it.
For the sake of an example, the compound interest that will be accrued on $100, which is annually compounded at 10%, will be lower than the principal value, as compared to the same amount being compounded at the same time with a semi-annual compounding of 5%.
As the concept of interest levied on interest can be very effective in increasing the returns on your investments. Hence, it is termed as the eighth wonder of the world by Einstein, and also called the ‘miracle of compound interest’.
How To Calculate Compound Interest?
The compound interest on your investments can be calculated by multiplying your principal amount of investment with the annual rate of interest plus 1, raised to the power of total compound period minus one.
The resultant of this formula is then subtracted from the initial amount of your loan. For example, if you take a loan of $10,000 for three years at an interest rate of 5% compounded annually, the amount of interest on it will be $1,576, based on the formula.
Mathematically, it can be interpreted as: Compound interest = [P (1 + i)n] – P
Here’s a breakdown of the various parameters used in the calculation of compound interest:
- P: It is the principal amount of your loan or deposit
- I: It is the nominal rate of interest on an annual basis in terms of percentage
- N: it is the number of compounding periods on your deposit
Using the above formula, you can easily calculate the compound interest on your loan or deposit. Calculating the compound interest before choosing a policy allows you to gain the most promising returns, Moreover, you can also use a compound interest calculator for this purpose.
How Does Compound Interest Grow?
Keeping the example stated above in mind, it can be easily identified that accumulated interest incurred in the earlier periods is also considered for compound interest. Moreover, it is also observable that the interest amount need not necessarily be the same for all the years, as it is based on simple interest.
As you saw in the example, the total payable interest for three years is $1,576.25. Gradually, in 30 years, it will continue to grow and reach somewhere around $40,000 based on your policy preferences.
What’s The Role of Compounding Periods?
While you calculate the compound interest for your returns, the number of compounding periods in your investment can make a major difference. As a general rule of thumb, you need to keep in mind that the higher the amount of compounding periods in your policy, the greater will be the compound interest. With the capabilities of compound interest, you can boost the returns offered by your investments to a great extent and also allow you to choose the best insurance policies as per your needs.
Using Online Calculators to Determine Compound Interest
There is a wide range of compound interest calculator tools available online that can be used to calculate compound interest for your investments through an intuitive and user-friendly interface.
These calculators are available on the website of several major insurance companies. These tools also allow you to make your calculation more accurate by allowing you to include actual beginning and ending dates, including the continuous compounding option.
Moreover, there are also a handful of compound interest calculator tools that allow you to calculate your compound interest in different currencies, as well as include factors like deposits and withdrawals.
In case you want to make your calculations even more accurate, you can also incorporate inflation-adjusted increases to the deposits and withdrawals to enjoy automated advanced calculation of compound interest for your plan.
Compound Frequency – What You Need to Know?
The returns can be compounded on any prespecified frequency schedule, regardless of whether it is daily or annually. Generally, financial instruments use the standard schedules of compounding frequency, and for a common savings bank account, the compounding schedule is set to daily.
For a current deposit, there can be various compounding frequencies such as daily, semi-annually, or monthly. Talking about mortgage loans of home, business, or credit cards, the most usual form of the compounding schedule is monthly.
The variations can also be seen in the time frame under which the accrued interest is transmitted to the current balance. Although an investment’s amount of interest can be compounded daily, you still need to wait for at least a month to get it credited.
Moreover, unless the interest has been added or credited to the existing balance, it won’t be able to gain additional interest in the account. Some banks offer continuously compounding interest, which attempts to add interest to your capital at every possible event.
When you know how to calculate compound interest either manually or by using compound interest calculator tools online, you not only learn to determine a good policy for yourself but also allow yourself to grow your returns to a great extent.
Hopefully, if you’re reading this far, you may now have a better idea about compounding and compound interest. This knowledge will help you very much in making effective financial investments and identifying the best insurance policies for a bright future.