How Compound Interest Works

Too many people have no idea how compound interest works. Not understanding this very simple aspect of your finances can lead to financial disaster; on the flip side, gaining an understanding of compound interest can help your finances improve if you use the information you learn to make positive changes to your financial life.

Frugal living experts much smarter than me have written plenty about the impact compound interest has on your financial success; here’s one frugal living writer who urges you to teach your kids about compound interest and shows you how to do it. Still other frugal living writers suggest that a lack of understanding of compound interest is the main reason why many of us are in the financial mess we’re in, and champion a new understanding of compound interest as our country’s economic savior.

Here’s a quick guide to how compound interest works, written in plain English. Use this information to revamp your finances and simplify your life. All of us can live more frugally, especially if we understand the simple concept of compound interest and the effect it can have on our money.

Interest is a fee charged for borrowing money. We pay interest on any and every line of credit we establish. Interest is usually represented as a percentage charged against the principle amount of a loan for a period of a year, though interest can also be represented in terms of longer than a year.

To figure out how much compound interest you will earn on a given investment, remember that compound interest is paid on the original principal of the loan AND on the accumulated past interest.

But we also earn interest on bank accounts and other investments. For a standard bank account, compound interest is the fee the bank pays you for allowing them to use your money to make investments.

Here’s a simple formula for figuring out compound interest:

Let P stand for the principal (the initial amount of the loan you borrow or the amount you deposit at a bank)
Let r stand for the annual rate of interest (expressed as a percentage)
Let n stand for the number of years the amount is deposited or borrowed for, the term of the credit.
Let A stand for the amount of money accumulated after n years, including all interest earned.

For interest that is compounded once a year, use the formula:

A = P(1 + r)n

For interest that is compounded multiple times, you simply raise the original formula to the number of the term you’re interested in. For example, for interest on a borrowing period of 5 years, the formula is:

A = P(1 + r)5

These basic formulas can help you work out the compound interest on all your lines of credit, including the credit you extend to your bank by depositing cash.