What is the formula for calculating compound interest?

by

Understanding Compound Interest

Compound interest is a powerful financial concept that allows your money to grow over time. Unlike simple interest, which is calculated only on the principal amount, compound interest is calculated on the principal plus any interest that has already been added to the account. This means that you earn interest on your interest, leading to exponential growth of your investment.

The Compound Interest Formula

The formula to calculate compound interest is:

A = P (1 + r/n)^(nt)

Where:

  • A = the amount of money accumulated after n years, including interest.
  • P = the principal amount (the initial amount of money).
  • r = the annual interest rate (decimal).
  • n = the number of times that interest is compounded per year.
  • t = the number of years the money is invested or borrowed for.

Example Calculation

Let’s say you invest $1,000 at an annual interest rate of 5% compounded annually for 3 years. Here’s how you would calculate it:

  1. Identify the variables:
    • P = $1,000
    • r = 0.05 (5% as a decimal)
    • n = 1 (compounded annually)
    • t = 3 years
  2. Plug these values into the formula:
    3. A = 1000(1 + 0.05/1)^(1*3)
  3. Simplify and solve:
    4. A = 1000(1 + 0.05)^(3)
    A = 1000(1.05)^(3)
    A ≈ 1000 * 1.157625
    A ≈ 1157.63

After 3 years, your investment would grow to approximately $1,157.63. That’s the power of compound interest!

Conclusion

Understanding and applying the compound interest formula is crucial for effective financial planning. By strategically investing your money and taking advantage of compounding, you can enhance your wealth over time.

Leave a Comment