Understanding the compounded interest equation is one of the key components of maintaining and growing your savings account. Because it is basically interest that also earns additional interest, there is room for substantial growth if you simply don’t touch your money over a long period of time.
A Closer Look at Calculating Compound Interest
If you’re opening a savings account, IRA or other form of savings and want compound interest to work for you, it’s important to understand just what it means. The basic concept in calculating compound interest is that both your principal balance and accrued interest will earn a return. This means the interest you accumulate will also begin to earn interest as well.
The Compounded Interest Equation
To give you an example of how funds are added up, consider the following example of depositing $5,000 in the bank (your principal amount) and having it compound semi-annually (twice per year) at 10% APR (annual percentage rate):
First 6 Months: $5,000 (principal) x 0.05 (interest) = $250 + $5,000 = $5,250
Next 6 Months: $5,250 (principal) x 0.05 (interest) = $262.50 + $5,250 = $5,512.50
How Compound Interest Works
Now compare this year-end total to what you would have received if you’d only calculated using simple interest, which earns only once a year: $5,500.
While a $12.50 gain doesn’t seem like much now, just imagine how much you could gain by adding more to your principal amount, compounding more often, and allowing interest to add up over many years. Better, right?
Compound Interest Works Best on a Long-Term Basis
If you’re looking for quick money then working with compound interest in a savings account is probably not the best option for you. Individuals who take this route are generally interested in saving for the long term and want to build a substantial nest egg.
If you’re seriously considering a savings account with compound interest, it’s good to know that starting early, making regular investments, and being patient (not touching your money) will make for a successful saving experience. To learn more, contact your local financial institution for accurate rates and starting deposit amounts.
