- Education and Science
How to Calculate Interest, Compound both short & long methods
When you deposit money into a saving account or interest bearing account the financial institutions uses that money for various purposes such as lending it to other people. The financial institution than pays you an interest for letting them use your money.
This is similar to when you use a credit card and the company charges you interest for borrowing their money. The original amount of money you borrowed is called the principal.
Compound Interest (Long Method)
Let's start with the principal. The principal we are going to use is $100 and the interest rate is 4%.
For the first example we are going to compound the interest annually. Which means once a year the interest gets added and becomes part of the principal.
Year 1 = $100 x 1.04 = $104
Year 2 =$104 x 1.04 = $108.16
Year 3 = $108.16 x 1.04 = $112.49
Year 4 = $112.49 x 1.04 = 116.99
Notice that each time the amount compounds there is a new principal which allows the money to grow. Now compounding in this manner of a large term will be time consuming and unnecessary.
Compound Interest (simple method)
The formula looks like this
Principal x (1 + interest rate )^(number of terms)
The number of terms is how many times the interest is being added and compounded.
Let's Talk Terms
So far we have only been looking at annual terms but there are many different types of terms and it dramatically changes the amount of money that one can make in interest. Having a monthly compounding account can significantly change the amount of interest because now we are compounding it 12 times a year. So for 4 years we are looks at 4 x 12 = 48 times that the account accrues interest instead of 4.
Keep in mind that most saving accounts the interest similar to 0.04% which is 0.0004 so when you add 1 to make it the multiplier it look more like 1.0004. BOO. No one is getting rich quick with those savings accounts.