Also known as compounding interest, the compound interest formula can be complicated. Most people are familiar with the idea of interest building on top of itself, but that doesn’t mean this is easy to understand in practice. Unlike simple interest, compound interest grows at a faster rate since it’s calculated not only on the principal amount.
There are a lot of factors that go into compounding interest. For example, if there’s a greater number of compounding periods, there will be even more interest throughout the lifetime of the debt. If you’re considering your long-term debt payoff goals, it’s important to take a closer look at the compound interest formula explained in detail.
How Does Compound Interest Work?
To begin, how does the compound interest formula work? In simple terms, this works by multiplying the initial principal amount plus the annual interest rate by the number of compound periods minus one. This type of interest is calculated on the initial principle, and it takes into account all of the accumulated interest over the previous life of the loan.
With that in mind, you can think of compound interest as the total amount of principle and interest value in the future minus the present value. Unlike simple interest, this grows at a fast rate. For simple interest, the loan (or investment) grows at the same pace over the life of the term. Because compound interest grows on itself, it truly can increase rapidly.
This can be both a good and a bad thing depending on the context. Compound interest in investing, for instance, is a great thing. It boosts your investment over long-term periods of time, making it worthwhile to start investing early in life. On the other hand, compound interest can increase the amount you owe for your debt, encouraging you to pay off loans faster.
What Is the Compound Interest Formula?
Next, let’s share the compound interest formula explained. This formula is:
Compound interest = [P (1 + i)n] – P
In this formula, the breakdown is as follows:
- P: Principal
- I: Nominal annual interest rate (as a percentage)
- N: The number of compounding periods
To understand this further, let’s review a real-world example. Let’s say you take on a 3-year loan of $10,000 at an interest rate of 7%. In this case, you would use the following formula:
- $10,000[(1+0.07)3 – 1] = $2,250.43
Over the 3-year period of your loan, the total payable interest is $2,250.43. Over time, the interest grows upon itself. The schedule of compounding interest depends on your bank or lender, and sometimes it can be accelerated.
This is especially true for payday loans which are notorious for predatory lending practices. Ultimately, it’s important to consider the long-term impact of compound interest. Want to continue to play around with the compound interest formula? Use a free calculator online.
How to Harness the Power of Compound Interest
Now that you know the formula and math behind compound interest, how can you use this as a tool for wealth creation? You might feel intimidated by the idea of saving for the future or paying down debt. These are sometimes confusing processes, and it takes a bit of know-how to get started. Luckily, by knowing a few things about compound interest, you can make the most of your money.
- Pay down high-interest loans.
First, make it a priority to pay down any high-interest debt. Carrying debt isn’t necessarily a bad thing, but it does impact your ability to save for the future. If you’re carrying debt with compounding interest, this easily spirals into something much greater than you took on in the first place. A debt payoff plan helps you achieve these goals.
- Create an emergency fund.
Before you can invest in your wealth, you need to invest in your safety. An emergency fund is a way to make sure you have money put inside for just that—emergencies. Without an emergency fund, you run the risk of diving deeper into debt every time you have an unexpected expense or cost.
- Invest in savings and the stock market.
Finally, when you’re ready, start investing in your own savings and the stock market. A high-yield savings account utilizes the power of compound interest to bring you greater returns. Similarly, the stock market uses compound interest investing to earn you money on investment assets.
Compound Interest Formula: Knowledge Is Power
When it comes to debt and managing your money, knowledge is power. The more you know about the formulas behind your banks and loans, the easier it is to get ahead of your goals.
Are you worried about your financial future? If you’re struggling with payments due to compound interest, the professionals at Debt Busters are here to help. Contact a member of our team to get started today.