Understanding Compound Interest

Keeping track of personal finances can be a somewhat daunting task for anyone. Between the hassle associated with rounding up all of the proper documents, the potential for disappointment when we see that we might be behind our financial goals, and the sheer amount of time that we need to spend making sure that we are setting ourselves back on track, it’s fairly easy to find an excuse to procrastinate this task off to another day.

compound interest equationHowever, financial planning doesn’t need to be a chore, and can actually be a fairly seamless process for an informed saver. The trick is to understand the financial math that goes into our daily lives, so that we can better see how our money is working in our daily lives, and what we need to do to make our savings work for us.

The most fundamental calculation for a personal saver to understand is the compounding interest equation. Compounding interest, as a concept, makes up the basis of any kind of banking, and is therefore has an impact on our savings, borrowing, and investing. Simply put, compounding interest represents the way in which an interest rate is broken down to accumulate on a daily basis, so as to be most efficient.

When interest compounds it will result in a higher interest amount being paid (or received), but also represent a much more efficient amount than simple interest (which is just paid off at the end of the period). From a debt perspective, we will see later on how it is that compounding interest is the reason why a debt is so cumbersome in the first half of a loan period, while it creates a much more appealing return from an investment and savings perspective.

Amount Earned=Principle (1+Annual RateCompounding Periods) Compounding Periods x Number of Periods

Compounding interest is calculated by dividing the annual interest rate by the number of compounding periods that are being considered in a greater term, while then multiplying the overall time period by that same number of compounding periods. The end result is that we will have a much smaller interest rate (on paper), but a much larger time period number. This result is then multiplied against the principle, to show how much money would be earned.

For example, if we invest $1,000 into a savings account that compounds daily at a rate of 3%/year, we would enter the following to determine how much money we have after 5 years:

$1161.83=$1000 (1+0.03365) 365 x 5

This shows how it is that the compounding interest paid us out a full $11.83 more than the simple interest equation would have. While that might not seem like much, that works out to make a major difference for larger principles, such as the amounts we would be dealing with in our retirement savings accounts.

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