We prefer to think of compound interest as a reverse credit card. We all know the problem with credit card debt; the interest charged makes it difficult to pay off the original, or principal, debt. Well the benefit of compound interest is that it can help you make money the same way credit card company’s do. In this article we will teach you how to calculate compound interest, and show some examples of how you can use it to your advantage.
Keep in mind when using this formula for compound interest that it is an annual calculation. The formula for compound interest looks fairly complicated, but its actually quite simple. Lets explain the variables in the compounding formula:
A – Amount (The future value of the loan)
P- Principal (The initial deposit amount)
R- Rate Of Interest (The annual interest rate)
N- Number of Compounds Per Year
NT- Time In Years (total years the money is invested for)
When looking at the number of compounds per year, remember you can have interest compounded monthly, semi annually, quarterly, or annually.
The Gage Canadian dictionary defines compound interest as, “the interest paid on both the original sum of money borrowed and on the unpaid interest that has accumulated.” Sound like something you’ve heard before?
Here is an example of how to calculate compound interest with a few numbers rounded off to make the calculations easier. You have $1000 dollars and open a savings account at a modest 3 percent per annum interest rate. That is you lend the bank $1000 dollars and they pay you 3 percent interest on this amount of money annually. It’s a far cry from the 19.5 percent a credit card company charges, which reminds me if you do carry credit card debt forget about this article until you have paid off your debt in its entirety, there is no point in making a three percent gain only to have your credit card lose you that 3 percent and additionally another 16.5 percent. After one year in the bank your money will have grown from $1000.00 dollars to $1030.00 dollars. You’re thinking that this isn’t your idea of a miracle or phenomenon right? Well there are a few things to consider,
1. You only deposited $1000
2. The money was left untouched for only one year and
3. That 30 dollars was made while you were doing whatever you wanted, no active participation was required on your part.
So the $1000 dollar one year example wasn’t that exciting. Well let’s see what that $1000 dollars would yield if left untouched for 25 years. The formula for this calculation is 1000*1.0325; that is the amount of dollars multiplied by 1 decimal place the interest rate you receive to the power of the years you receive it for. The amount your money is worth after 25 years is $2093.77. So you doubled your money, still not so enticing? Well, replace the initial amount of $1000 dollars with $25,000 and the annual rate of interest of 3% with 8%. After 25 years your money will have grown to $171,211.87.
It is important to note that with a long-term investment plan it is not unrealistic to have an average yield of 8%.
So in 25 years, without shifting in your seat or depositing any extra money you have made over $150,000.00 dollars. You can call that a phenomenon or a reverse credit card or whatever but there is no disputing the fact that it makes sense, and money. But what about the taxes you might ask? We will touch on the taxes a little later.
Essentially the longer your money compounds the more money it makes you. Similarly the higher interest rate you receive the more money you make. A prudent investor who seeks realistic returns will realize that it’s a safer bet to put your money in a less risky vehicle for a longer time as opposed to a potential high yield investment for a short while.
Compound interest is a miracle but getting away with it without paying taxes is a phenomenon that can take place in your RRSP. Your RRSP is an account that the government allows you to contribute to, in which your money will compound tax-free.
Memorizing the formula when learning how to calculate compound interest isn’t a necessity, as there is a compound interest calculator that will do it for you. But, before using a compounding calculator, make sure you know HOW compound interest works. We learn the multiplication table prior to using a calculator for a reason! Two important things to remember about compound interest; time will make you money and don’t spend the money that is compounding!