What is Compound Interest and how to Calculate it?
If you don’t know what compound interest is and how to calculate it, you’ve come to the right place to learn. In this article you will learn a little about its different aspects, as well as how to calculate it.
Stay here and you will be able to solve all the doubts you have regarding this topic. So you can apply it in your studies or in your working life, depending on the case in which you need it.
What really is compound interest and how to calculate it?
Before knowing what compound interest is and how to calculate it, it is necessary to learn about interest in general. This refers to the profitability of savings, credit costs or investments made.
Within finance and economics, interest is related to the profit produced by capital. From the moment a capital or any type of investment is invested , the interest is the profit.
Now, speaking of compound interest, this is given thanks to the accumulation of interest generated in a given time. The principal has been invested at an interest rate during different application periods.
When these periods are fulfilled, all the interest that has been generated is reinvested, increasing the capital. This means that there is a greater number of interests when the next period is fulfilled.
It is a process that helps interest accumulate to generate much more. Many people do this in order to have a higher profit within each exercise to achieve a higher compounding.
At the end of the periods, the interest result is much higher than it would have been with the simple.
What are the main characteristics of this type of interest?
It is time to mention some of the characteristics that we can find in this type of interest. This way you can be much clearer about the different functionalities that this type of financial tool has.
- What differentiates it from simple interest is that with this financial model a capital reinvestment can be made. Thus, the user will be able to achieve a greater capitalization.
- The interest earned will be higher and higher. Similar to a snowball in which there is more profitability to increase capital.
- You cannot use the different interests generated until the end of the established period. Something that can be done with simple interest, where profits are generally withdrawn.
It is clear that its effect is to be an investment multiplier, since higher profits will be obtained. Long-term investments have compound interest as their main ally for this reason.
To explain it better, we will show you an example of how compound interest works.
A person invests about 5 thousand euros, with simple interest at 2% for a period of one year. The earnings that you will have at the end of the period will be 100 euros, that is, you will have about 5,100.
Now, with compound interest, a person invests the same 5,000 euros at 2% for 12 years. In the first year, you will have the same profit of 100 euros, but this can be reinvested.
This means that at the end of 12 years your profit will be 6,341.12 euros. The interest received is much higher, so, as we already mentioned, it is ideal for those long-term investments.
How is compound interest calculated?
In the world of finance, this type of interest is calculated through a specific formula. Through it, it is possible to do the mathematical operations to obtain the final result.
It will not be necessary for you to calculate month by month how much the earnings will be, until the established period is fulfilled. With this formula you can include the time that the period will last to know your earnings, according to your initial investment.
The formula is: Cn = C0 (1+i) ^n
- Cn: Capital final
- C0: Initial capital
- i: Interest rate
- n: The number of applicable periods in the term
In the case of the example, the substitutions are made in the following way, to proceed to the calculation of the compound interest. So the formula with the example will be as we show you below.
- C0: 5 thousand euros
- i: 2% or 0.02
- N: 12 years old
Cn = 5.000 (1+0.02) ^12
Cn = 6,341.12 euros at the end of the 12-year period
With this calculation you can clearly have the figures that will be handled at the end of the period. This serves so that many users can take into account their earnings.
In addition, some use it to be able to invest more or even less, as appropriate in each case. The truth is that it results in an easy process to carry out as long as you are clear about what you want.
It is important to know what compound interest is and how to calculate it
Now that you know what compound interest is and how to calculate it, its importance is much clearer. Especially for those people who want to carry out investment projects, it usually has a very high return during the process.
The difference it generates in relation to simple interest within the financial model is much greater. This is one of the main secrets to be able to have a larger and constantly growing initial capitalization.
As you become familiar with this type of interest, the more you can get out of it. All this serves so that you can establish a stronger heritage in which debts are minimized.
Depending on your projects, you can make your investments with a compound or simple interest rate. Remember the characteristics that these have and how the compound can generate much more profit in the long term.