Calculating interest is a function of Future Value, Present Value and the number of periods interest is applied. Compound interest applies to the principle, and earns interest as well. Simple interest earns on the principle only. Simple interest is very easy to calculate, but is not really used in modern investing. Compound interest is ultimately the Future Value of a principal less the Present Value at which it was invested.
Learn the formula:
I = P x r x n
Where: I = Interest paid P = Principle r = rate (as a percent) n = no. of periods
Multiple the principle borrowed or invested (P) by the interest rate (r) and by the number of periods the interest is applied. For example:
$100 at 8 percent for 10 years, with interest applied annually, will yield simple interest of $80.
Learn to use compound interest. Compound interest is interest that is added to the principle. This is where Future and Present Values come in.
Understand that compound interest earned on a principle is found from the Future Value of the principle. Once Future Value is known, Compound Interest earned is the Future Value less the Present Value.
The Future Value equation is:
Fv = Pv (1 + r )^ n
Where: Fv is Future Value Pv is Present Value r is the percentage rate n, an exponent, is the no. of periods
Plug in the numbers and go. Example: How much is $100 worth invested at 8 percent interest for 10 years, compounded quarterly?
Pv = $100 r = 0.08 n = 40 (4 quarters in a year, 10 years term)
Fv = $100 x (1.08)^40 = $2,172.45
Subtract the Present Value from the Future Value. Interest earned is:
$2,172.45 - $100 = $2,072.45
Compounding interest makes a large difference. It would take more than 271 years for the same interest to be paid via simple interest.
The great Physicist, Albert Einstein, famously quipped, when asked what was the most powerful force in the universe, "The most powerful force in the universe is compound interest."
- The great Physicist, Albert Einstein, famously quipped, when asked what was the most powerful force in the universe, "The most powerful force in the universe is compound interest."
Ben Williams is an award-winning reporter and freelance writer based out of Colorado. He has written for conglomerates of newspapers and magazines, supplying news, features, editorial and opinion. While running an Energy Services and Consulting firm, he now writes for multiple websites including the news site, Examiner.com.