Compound interest is the way that your total interest earnings are calculated when you keep them in your savings account, rather than withdraw them from your account total.
The formula that you can use to determine the amount of interest you’ll earn over a given period is widely available and easy to use. You can do this by inputting the required numbers into the following calculation:
Final balance = principal x (1 + (interest rate ÷ compound frequency)) time periodÂ
In more simple terms, you can follow this calculation like so:
- Divide the interest rate by the increments over which your interest compounds. For example, most interest compounds monthly, so you would divide your interest rate by 12 to find the monthly rate.
- Add 1 to this number and multiply this total to the power of the period over which you’re wishing to calculate your interest. Using the example above, you might wish to calculate your interest accrued over the course of a year, so this would be to the power of 12.
- Multiply this number by the initial principal and you’ll have the final account balance at the end of your chosen period. To work out the interest accrued, simply subtract the principal from the final balance.
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To apply this to a real example, you can use the following calculations. Working out your final balance in a high interest savings account after one year with a principal of $5,000 and an interest rate of 1% that compounds monthly would go as follows:
0.01 ÷ 12 = 0.00083
0.00083 + 1 = 1.00083
1.00083 12 = 1.01005
1.01005 x $5,000 = $5,050.23
$5,050.23 = $5,000 x (1 + (0.01 ÷ 12)) 12
In this instance, the final balance after one year would be $5,050.23, meaning that you will have accrued $50.23 in interest over the course of your first 12 months using the account. To make things simpler, though, you can work out your overall interest using Savvy's online savings calculator.
While it may seem an insignificant difference in the short term, you should be aware of how much money you can earn over an extended period with a better interest rate. Take a look at the rate table below to see the sort of difference you can expect between interest rates over time.
