# How To Calculate Compound Interest

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Interest is the price of money. For savers, it means how much the bank pays you to deposit money. For borrowers, it’s the amount of money the lender charges you. Compound interest increases the more often interest is paid.

### Key Takeaways

• Compound interest is interest paid on interest.
• Interest is higher the more frequently it’s compounded.
• Compound interest works for savers and against borrowers.

## How Do You Calculate Compound Interest?

The simplest way to calculate compound interest is year by year. You will need to know some information about your loans to calculate the compound interest.

The first things you’ll need to know are the initial investment, represented in the equation as P, and the interest rate, represented by r.

You’ll also need to know the number of times your interest rate is compounded (n) each year. For example, a loan with monthly compounding interest would compound 12 times in one year. One with interest that compounds quarterly would do so four times. The last thing to know is the length of your loans in years (t).

### Note

A simpler way is to use our compound interest calculator. You can find it here. Just enter the deposit, annual contributions, interest rate, and frequency.

Once you have all that information, you can plug it into the compound interest formula:

A = P (1 + r/n)nt

You can perform the math on a calculator or in a spreadsheet to get the total amount of money you will have or owe at the end of your investment or loan.

## How Compound Interest Works

The combination of time and compound interest is a powerful financial tool that can work hard for you when you’re saving for retirement, education expenses, or other long-term goals. It can also work against you on your business line of credit or other financing arrangements.

### Example of Compound Interest

Let’s look at a retirement plan, saving \$10,000 per year beginning at age 35. Assuming you get 4% interest for the next 30 years, our calculator shows that you’d have \$560,849 when you retire. Your \$300,000 contribution will have earned \$260,849 in interest.

If, instead, you started five years earlier at age 30, you would have \$736,522. For an additional \$50,000 in contributions (\$10,000 per year), your balance would be \$175,673 more.

### Note

Another way to look at the power of time and compound interest is the Rule of 72, which says if you divide 72 by your interest rate expressed as a whole number, the answer is the number of years it will take to double your money. For example, it takes nine years to double your money at an 8% rate of return.

## Compound Interest vs. Simple Interest

The difference between compound and simple interest is how it is added to the principal balance.

Compound interest adds interest due to the principal balance, and simple interest doesn’t. Simple interest is calculated by the principal time, the interest rate, and the amount of time on your loan.

For example, if you had a \$10,000 loan with 5% interest rate for two years, the accrued interest would be \$1,000. No interest is added to the principal balance.

If the interest in the same loan was compounded monthly, your total interest would be \$1,049.41.

## How do you invest your money to enjoy compound interest?

Some investments automatically compound interest, while others don’t. Certificates of deposit typically compound daily or monthly. U.S. treasury bonds pay simple interest, usually twice per year. Remember, compound interest is interest paid on interest. As long as you reinvest interest payments, you’ll get the benefits of compounding.

## Where do banks put their money to earn compound interest for savings accounts?

Banks are financial intermediaries. They compete for your deposits so they can lend the money to businesses and families for expansions, mortgages, car loans, etc. at a profit.