How to calculate compound interest

Compound interest is a powerful financial concept that can help you grow your savings over time. It can be used to invest for retirement, build an emergency fund, save for a big purchase and for many other savings goals. We'll go over the basics, why it's important and how to calculate compound interest so you can make your money work harder for you.

What is compound interest?

Compound interest is interest that is earned on both the principal amount and previously earned interest. For example, if you deposit $100 in a savings account that compounds interest, it will earn interest on $100 in the first period. In the next period, it will earn interest on the $100 plus the previously earned interest. Over time, this process causes your account balance to grow at an increasingly faster rate, which helps boost your savings.

Compounding frequency plays an important part in calculating compound interest. An account could compound daily, monthly, quarterly, semi-annually or annually. The more frequently an account compounds, the faster it will grow because interest is added to the balance more often.

Not all accounts or investments earn compound interest, however. It depends on the financial institution and the specific account features. An account may earn simple interest instead, which is when interest is earned only on the principal amount and not on any previously accrued interest. Accounts that earn simple interest will grow slower than those that earn compound interest. When you're opening a new account, be sure to research what type of interest it earns. And if it earns compound interest, check the frequency.

When is compound interest used?

Several types of accounts and investments earn compound interest. Some have low minimum balance requirements, which allows you to start saving right away. Accounts with higher minimum balance requirements often offer better annual percentage yields (APYs) or terms.

Common accounts that compound interest include:

• Savings accounts
• Money market accounts
• Certificates of deposit (CDs)
• Retirement accounts
• Mutual funds
• College savings plans
• Exchange-traded funds (ETFs)

Just as compound interest can be used to grow your savings, a loan or credit card can also charge compound interest, which can increase the total amount you owe when you borrow money. Credit cards are the most common example. If you are only able to make the minimum required payments on your credit card account each month, it can cause a snowball effect, where the total amount you owe grows rapidly.

How to calculate compound interest

Determining how much you can earn over time can help you compare different savings accounts or investments. It helps you choose the option with the best rate of return to maximize account growth.

The formula to calculate compound interest is:

A = P(1+r/n)nt

Where:

A = Future amount including total interest

P = Principal amount (initial investment)

r = Annual interest rate (converted to a decimal point)

n = Number of times interest is compounded annually

t = Number of years money is invested

Before you can calculate compound interest, you need to convert the interest rate to a decimal if it's a percentage. You can convert it by dividing by 100. For example, an interest rate of 5% becomes 0.05 (5 ÷100 = 0.05). You can then plug the values into the compound interest formula to determine the future value of your investment.

Thankfully, you don't have to worry about doing all of this math to find out how much you can earn. Online compound interest calculators are available to help you quickly crunch the numbers, like this one. Using a calculator saves time and reduces the chance of errors so you can make quick investment comparisons.

Compound interest calculation example

Reviewing compound interest examples is one of the best ways to understand how the calculation works and to see how much your money can grow over time.

Let's say you invest $2,000 in an account with a 4% interest rate that's compounded monthly (12 times a year) for two years.

The first step is to identify the values:

A = Final amount (principal + interest)

P = $2,000

r = 4% or 0.04

n = 12 times a year

t = 2 years

Next, plug the values into the formula:

A = $2,000(1+0.04/12)(12×2)

Then, simplify the equation:

A = $2,000(1+0.0033333)(12×2)

A = $2,000(1.0033333)24

A = $2,000 × 1.083142

A = $2,166.28

Your investment of $2,000 will grow to $2,166.28 in two years when interest compounds monthly.

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