Compounding Interest vs Simple Interest
Whether you're estimating future earnings or how large your loan balance will balloon after years of not making payments, calculating interest accurately is vital to financial planning. "Simple interest" and "compound interest," are both methods of calculating how much interest accrues on an account. While simple interest is the shorter calculation, compound interest is more accurate.
How Simple Interest Works
Simple interest is a quick way to estimate how much an account will be worth or how much you'll owe on a loan after a specific period of time. For example, you might owe $50,000 on student loans, which charge 6 percent interest per year.
If you put them in "forbearance" for two years — meaning you don't make any payments but interest keeps accruing — you can estimate how much interest will accrue on the loans by multiplying $50,000 by 0.06 per year by 2 years. After two years, your balance would have increased by $6,000 using the simple interest formula.
How Compound Interest Is Different
Compound interest accounts for the additional interest that collects on each interest payment that's charged or earned. For example, imagine you're planning for retirement and you want to know how much your $30,000 nest egg will be worth in 20 years if it earns 7 percent each year.
You'd make $2,100 in interest the first year. The compound interest formula accounts for the fact that for the next 19 years, you'll earn 7 percent not only on your original $30,000, but also on the $2,100 earned in the first year and in subsequent years — increasing the amount you end up with after 20 years.
Calculating Compound Interest
Calculating compound interest isn't as easy as calculating simple interest, but don't let the extra steps intimidate you, because it will give you a more accurate result.
First, determine how often interest compounds by multiplying the compounding periods per year by the number of years. Second, divide the annual rate by the number of times interest compounds per year. Third, add 1 to the result and raise the result to the power of the number of times interest compounds. Fourth, multiply the result by the initial balance.
A Compound Interest Calculation Example
If you earn 7 percent compounded monthly for 20 years, there are 240 compounding periods. Dividing 0.07 by 12 — because the return compounds 12 times per year — gives you a periodic rate of 0.0058333.
Adding 1 brings you to 1.0058333. Raise 1.0058333 to the 140th power to get 4.0387. Multiplying your initial balance of $30,000 by 4.0387 means that in 20 years, your new retirement balance will be $121,161 — a much more accurate estimate of your retirement fund.