Difference between revisions of "Calculate Compound Interest Payments"
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Compound interest is interest that builds upon its own previous interest over the initial balance. In other words, interest that is not paid within the pay period gets even more interest compounded on top of it. This results in a larger interest payment over time if the balance is not paid off within the first compound period. | Compound interest is interest that builds upon its own previous interest over the initial balance. In other words, interest that is not paid within the pay period gets even more interest compounded on top of it. This results in a larger interest payment over time if the balance is not paid off within the first compound period. | ||
| − | [[Category:Managing Your Money]] | + | [[Category: Managing Your Money]] |
==Steps== | ==Steps== | ||
===Understanding Compound Interest=== | ===Understanding Compound Interest=== | ||
| − | #Understand the meaning of interest. Interest can be calculated for loans or for investments. For a loan, interest is the amount paid to the creditor for granting the loan to you. For an investment, interest is income that the investment earns.<ref>http://www.investopedia.com/terms/i/interest.asp</ref> | + | #Understand the meaning of interest. Interest can be calculated for loans or for investments. For a loan, interest is the amount paid to the creditor for granting the loan to you. For an investment, interest is income that the investment earns.<ref name="rf1">http://www.investopedia.com/terms/i/interest.asp</ref> |
| − | #*Interest for a loan is usually expressed as an annual percentage rate, which is the annual rate that is charged for borrowing the money.<ref>http://www.investopedia.com/terms/a/apr.asp</ref> | + | #*Interest for a loan is usually expressed as an annual percentage rate, which is the annual rate that is charged for borrowing the money.<ref name="rf2">http://www.investopedia.com/terms/a/apr.asp</ref> |
| − | #*Interest on an investment is usually expressed as a percentage.<ref | + | #*Interest on an investment is usually expressed as a percentage.<ref name="rf1" /> |
#*The two main types of interest that can be applied to loans are simple and compound interest. Simple interest is calculated by multiplying the interest by the principal by the number of periods. | #*The two main types of interest that can be applied to loans are simple and compound interest. Simple interest is calculated by multiplying the interest by the principal by the number of periods. | ||
| − | #*Compound interest, however, is the most commonly used method of applying interest to a loan or investment.<ref | + | #*Compound interest, however, is the most commonly used method of applying interest to a loan or investment.<ref name="rf1" /> |
| − | #Define compound interest. Compound interest is interest calculated on the original principal plus interest calculated on the accumulated interest from previous accounting periods. The rate at which the interest accrues, or accumulates over time,<ref>http://www.investopedia.com/terms/a/accrue.asp</ref> depends on how often the interest is compounded. Interest can be compounded annually, monthly or quarterly.<ref>http://www.investopedia.com/terms/c/compoundinterest.asp</ref> | + | #Define compound interest. Compound interest is interest calculated on the original principal plus interest calculated on the accumulated interest from previous accounting periods. The rate at which the interest accrues, or accumulates over time,<ref name="rf3">http://www.investopedia.com/terms/a/accrue.asp</ref> depends on how often the interest is compounded. Interest can be compounded annually, monthly or quarterly.<ref name="rf4">http://www.investopedia.com/terms/c/compoundinterest.asp</ref> |
| − | #*Compound interest is not beneficial for those in debt. If a person carries a credit card balance on a high-interest credit card for which the interest is compounded monthly, the interest payments alone could be hundreds of dollars per month.<ref> http://www.investopedia.com/terms/c/compoundinterest.asp</ref> | + | #*Compound interest is not beneficial for those in debt. If a person carries a credit card balance on a high-interest credit card for which the interest is compounded monthly, the interest payments alone could be hundreds of dollars per month.<ref name="rf5"> http://www.investopedia.com/terms/c/compoundinterest.asp</ref> |
#*Compound interest is advantageous to investors, because the interest that is earned each accounting period gets added back to the principal and earns more money for the investor. | #*Compound interest is advantageous to investors, because the interest that is earned each accounting period gets added back to the principal and earns more money for the investor. | ||
| − | #Learn the formula for compound interest. The annual compound interest formula is <math>P (1 + i)^n - P</math>. In this formula, P = Principal, i = annual interest rate in percentage terms, and n = number of compounding periods. If the interest is compounded more than once per year, such as monthly (12 times per year) or quarterly (four times per year), the formula must be adjusted,<ref | + | #Learn the formula for compound interest. The annual compound interest formula is <math>P (1 + i)^n - P</math>. In this formula, P = Principal, i = annual interest rate in percentage terms, and n = number of compounding periods. If the interest is compounded more than once per year, such as monthly (12 times per year) or quarterly (four times per year), the formula must be adjusted,<ref name="rf3" /> |
| − | #*The formula for compound interest that is compounded multiple times per year is <math>[P (1 + i/n)^{n*t}] - P</math>. In this formula, P = Principal, i = interest rate, n = number of compounding periods, and t = the number of years for which the money is invested or borrowed.<ref> http://www.thecalculatorsite.com/articles/finance/compound-interest-formula.php</ref> | + | #*The formula for compound interest that is compounded multiple times per year is <math>[P (1 + i/n)^{n*t}] - P</math>. In this formula, P = Principal, i = interest rate, n = number of compounding periods, and t = the number of years for which the money is invested or borrowed.<ref name="rf6"> http://www.thecalculatorsite.com/articles/finance/compound-interest-formula.php</ref> |
| − | #Understand the Rule of 72. You can use the rule of 72 to figure out how long it will take to double your money on an investment that is earning compound interest. Divide 72 by the annual interest rate your investment is earning. The answer will tell you how many years it will take for your investment to double in value.<ref> http://www.thecalculatorsite.com/articles/finance/what-is-compound-interest.php</ref> | + | #Understand the Rule of 72. You can use the rule of 72 to figure out how long it will take to double your money on an investment that is earning compound interest. Divide 72 by the annual interest rate your investment is earning. The answer will tell you how many years it will take for your investment to double in value.<ref name="rf7"> http://www.thecalculatorsite.com/articles/finance/what-is-compound-interest.php</ref> |
#*For example, if your investment is earning a 3 percent interest rate, calculate how long it will take to double your money using the equation <math>72/ 3=24</math>. In 24 years, your investment will have doubled in value. | #*For example, if your investment is earning a 3 percent interest rate, calculate how long it will take to double your money using the equation <math>72/ 3=24</math>. In 24 years, your investment will have doubled in value. | ||
#*Interest rates on investments do fluctuate, so the rule of 72 should be used as a tool for estimating the future value of your investments. | #*Interest rates on investments do fluctuate, so the rule of 72 should be used as a tool for estimating the future value of your investments. | ||
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===Calculating Compound Interest Payments on Loans=== | ===Calculating Compound Interest Payments on Loans=== | ||
| − | #Understand how compound interest works in loans. Compound interest is calculated on loans using the same formulas. However, instead of earning you a lot of money, compound interest on loans can cost you a lot of money. High interest rate credit cards, for example, often compound interest monthly. This means that if you are carrying a balance, the amount you have to pay back grows exponentially every month.<ref | + | #Understand how compound interest works in loans. Compound interest is calculated on loans using the same formulas. However, instead of earning you a lot of money, compound interest on loans can cost you a lot of money. High interest rate credit cards, for example, often compound interest monthly. This means that if you are carrying a balance, the amount you have to pay back grows exponentially every month.<ref name="rf7" /> |
#Calculate annual compound interest. Suppose you had a credit card on which you were carrying a $20,000 balance. The interest rate is 20 percent compounded annually. Calculate how much interest will accrue on the balance due in two years with the formula <math>[P (1 + i)^n] - P</math>. | #Calculate annual compound interest. Suppose you had a credit card on which you were carrying a $20,000 balance. The interest rate is 20 percent compounded annually. Calculate how much interest will accrue on the balance due in two years with the formula <math>[P (1 + i)^n] - P</math>. | ||
#*In this example, P = $20,000, i = .2 and n = 2. | #*In this example, P = $20,000, i = .2 and n = 2. | ||
