What is Compound Interest?
When you borrow money, it’s more than likely you’ll be required to pay interest. Compound interest is one method of calculating the interest expense owed for borrowing the principal amount. Albert Einstein is said to have called compound interest “the most powerful force in the universe”—for its power to build wealth, or debt, exponentially.
Calculating Compound Interest:
For example:
You have borrowed $200,000 at a 6.5% interest rate, compounded annually for 3 years.
- Year 1 Calculation:
$200,000 x .065 for one year = $13,000 interest in one year - Year 2 Calculation:
$213,000* x .065 = $13,845
*($13,000 is added to the principal and 6.5% is calculated on the new amount of $213,000) - Year 3
$226,845 x .065 = $14,744.925 - Total at the end of 3 years = $241,590
How is compound interest calculated?
- Compounding means combining. With compound interest, both a loan’s original principal and the amount of unpaid interest are added or combined.
- The loan’s interest rate is then computed on the sum.
- As a result, with compound interest, the borrower pays interest on the interest they owe. In the meantime, the lender earns interest on the interest they’re earning.
Financially savvy consumers apply the principle of compound interest to build their own wealth. Consider making the principle of compound interest work for you, by eliminating debt and building savings.
Alternatives to compound interest
- hile seldom used, simple interest is the alternative to compound interest. It features the calculation of interest against only unpaid principal, so interest grows in a much more linear fashion than with compound interest.
