How to calculate compound interest



How to calculate compound interest

The benefit of calculating compound interest

Knowing how to calculate compound interest can help you to make informed financial decisions independently. Using this techniques, you can choose among savings/investment plans, determine your pre-retirement income and more.

You can calculate compound interesting in a number of ways. There are tables (that use compounding factors), financial calculators, online calculators, spreadsheets and even a simple formula to use. Using the online calculator is the easiest way to calculate compund interest, since you just have to input the relevant data. However, this guide would give you a better understanding of how to calculate compound interest independently.


Instructions

Step 1

Calculating compound interest on principal with a normal calculator

Once the interest rate is the effective or annualized interest rate, you can even perform the calculation on a scientific calculator. However, if the interest rate is nominal, it is better to use a financial calculator for accuracy. The steps for using the formula are as follows:

  1. Convert the effective interest rate to a common ratio. For example, if your interest rate is 3%, then the common ratio is 1.03 (1 + 3/100). Likewise, if the rate of return is 10%, the common ratio would be 1.1 (1 + 10/100).
  2. Find the common ratio to the power of the number of years or months that compounding would occur. For example, calculating the compound interest on a five-year fixed deposit at 6% would be: 1.06 to the power of five. In this example, the result is 1.3382.
  3. The result from (2.) is the factor that you multiply by the principal. If the principal is $10,000.00, the accumulated cash value at the end of five years would be $13,382 ($10,000 X 1.3382).
  4. If you are trying to determin the compound interest for less than a year, all that you have to do is divide the number of months by 12. For example, if you want to know the accumulation at the end of 6 months, you use the common ratio to the power of 0.5 (6/12). For 2 months, it would be the common ratio to the power of 0.1667 (2/12).
Introduction to Compound Interest

A simple example of compound interest

Step 2

Calculating compound interest using the effective interest rate and a financial calculator

When using a financial calculator and the effective interest rate, you still have to ensure that your calculator is properly set.

  1. Check to see that the compounding periods on your calculator is set to one (1) and your payment period set to your desire as well. This allows the calculator to accept the interest as annualized.
  2. Use the Future Value set on the calculator, where N = Number of months, I/Y = Interest per annum, PV = Present value, PMT = Payment and FV = Future Value.
  3. Ensure that you enter the information according to the payment setting used in (1.) Therefore, if you’re calculating for year and a half, N = 18 (1.5 X 12 months).
  4. Once you enter the relevant data correctly, determine the future value of the future value of the principal by pressing the FV key.
E.g. future value with compounded interest rate.

How to use Financial Calculator to solve for future value.


Knowledge/ Tools Needed
• Interest Rate
• Basic knowledge of nominal and effective interest rates
• Working knowledge of a financial calculator
• Number of compounding periods
• Payment and/or principal
• Scientific/ Financial calculator

Tips & Warnings
• In using the common ratio, remember that the percentage is really a representative portion of 100. As such, 6% represented as a common ratio is not 1.6 but 1.06. The common ratio for 100% return is 2 (1 + 1).
• The basic calculation of compound interest (by formula) can be done with a scientific calculator.
• It is important to know whether the interest rate that you are using is nominal or effective. The Related Helium Articles section discusses the distinction and the importance of it in more detail.
• Ensure that the basic settings on your financial calculator (compounding periods/ payment periods) match what you intend to calculate.
• A common mistake when using the financial calculator is the type N = 2 for two years without checking the settings on your calculator. If your payment period is not set to one (annual) but 12 instead, then you are indicating that you want to determine the compound interest for two months.
• Double check your calculations. Minor differences can result in major errors when calculating interest on large payments or principal.

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