The Compound Interest Rate Formula
The Key to Successful Investment
Compound interest is a pretty old investment concept. The compound interest rate formula and concept has been around for a very long time. Its earliest appearance was seen during the Old Babylonian period (2000-1600 BCE). The concept reappeared again in the 17th century in Italy where it became more popular and widely used. The compound interest rate formula is the sure-fire way to multiply your wealth at a faster rate than other investments. Our purpose today is to educate you about compound interest and the intricacies of the compound interest rate formula. The more you know, the more comfortable you will be with choosing an investment that uses compounding.
What is compound interest?
Compound interest is interest calculated on the starting balance or deposit and also includes all of the accrued interest from previous time periods on your investment. The compound interest rate formula is applied to several types of investment accounts and loan facilities. It is an integral part of the financial construct utilized by banks, credit unions, and other financial institutions.
What is the formula for compound interest?
You may have come across it before but if you have not, the formula for compound interest is as follows:
X= P (1 + r/n)^(nt)
Do not be cowed by the formula, it really is quite user-friendly once you get the hang of it.
X= Final amount
P =Principal (The initial investment sum)
r = interest rate
n = the amount of times interest is applied per period
t = the number of time periods that have passed
Most things become easier if you can look at a working example.
So, if your lump sum or initial investment (P) is £2000, the interest rate is 5 % which when turned into a decimal is reflected at 0.05. The amount of times interest is applied per period, which is called compounding (n) is 12. The number is 12 because here, we are compounding monthly. The number of time periods that have elapsed (t) is 10 (years).
A = £2000 (1 + 0.05 /12)^(12 * 10) = £3,294.02
So, the investment balance after 10 years is £3,294.02
So, as you can tell you have made (£3,294.02-£2,000) =£1,294.02
Why use a compound interest calculator?
Because it’s easier than manually working out the compound interest rate formula!
If you type in the term compound interest or compound interest calculator on a search engine, you will see numerous options. These calculators allow you to slot in your principal or initial investment figure, your time period in years, the proposed compound interest rate, and the compound frequency. You are able to choose from drop-down boxes which give you the option of annually, bi-annually, monthly, weekly, and daily.
This is the best compound interest calculator we’ve found so far.
Mostly because it let’s you calculate your interest monthly and yearly.
You can also calculate your compound interest with Excel from Microsoft office. You simply input your figures into the formula provided by the software. You can also compare different compounding rates.
What does the term compound frequency mean?
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The term compound frequency means the number of times interest is credited to your initial investment or deposit.
Your interest can be compounded annually in which case n will be 1 and the example would look like:
A = £2000 (1 + 0.05 /1)^(1 * 10) = £ 3,257.79
Your interest can be compounded bi-annually in which case n will be 2 and the example, would look like:
A = £2000 (1 + 0.05 /2)^(2* 10) = £ 3,277.23
As our initial example showed above, your interest was compounded monthly in which case n is 12 (as you may have guessed because there are 12 months in the year).
For continuity, we will show the example again.
A = £2000 (1 + 0.05 /12)^(12 * 10) = £3,294.02
Your interest can be compounded weekly in which case n will be 52 (there are 52 weeks in the year), the example would look like:
A = £2000 (1 + 0.05 /52)^(52* 10) = £ 3296.65
And finally, your interest can be compounded daily in which case n will be 365 for the number of days in the year.
A = £2000 (1 + 0.05 /365)^(365 * 10) = £ 3,297.33
What compound frequency will earn me the most money?
Well, if you were paying attention to the numbers above, you will notice that the more often your interest is compounded the more money you make. So, it stands to reason that when your interest is compounded daily, you will earn more on your investment.
What types of investments use the compound interest rate formula?
There are several investment options that use the compound interest rate formula to calculate their returns. Here are a few that you can explore.
Most savings accounts utilize compounding. Any time you are looking to open an account or invest, we recommend that you ask how your interest will be calculated.
Money Market Accounts
Also known as money market deposit accounts. They often come with high interest rates than basic savings accounts. They utilize the compound interest formula to increase your deposit. While you can withdraw from this type of account, you need to maintain a minimum balance.
Certificates of Deposit
CDs also use the compound interest formula. Here you deposit a lump sum into the account and let it accrue interest for the pre-determined time. The key is not to touch the deposit.
Some types of bonds calculate your interest using the compound interest rate formula. One such example is zero-coupon bonds. With a zero-coupon bond, you pay less than the face value price. So, if your bond is £5000, you will pay the sum of £4500, Even though you will not receive interest payment during the term of the bond, at maturity, you will receive £5000. The difference of £500 represents the compounded interest payments.
It is undeniable that the compound interest rate formula is quite a useful investment tool. From what we can tell, it is unparalleled for its benefits. Our compound interest rates of 20% can more than compete with what most financial institutions will offer. The interest is calculated and paid quarterly. All you need to do is click on the link below for more details!
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