The Compound Interest Formula
MBA, BSc, DipFP
Financial Planner / Managing Partner
How To Make It Work For You & Not Against You!
It’s likely you have likely heard this term the compound interest formula, bandied around a lot in financial circles. Depending on the type of financial product you are talking about compound interest is either a ‘miracle’ or something far less desirable.
In essence, if you are talking deposit or income generating products, Compound Interest is your friend. If you are talking loan products, like credit cards, it is your worst enemy.
What Is It Really?
According to the Macquarie Dictionary, compound interest is:
“interest paid not only on the principal but on the interest after it has periodically come due and, remaining unpaid, been added to the principal”
There are all sorts of complicated formulas for calculating compound interest that relate to interest rates and periods, but let’s just keep it simple, because it’s really the principal that we need to understand.
The simplest formula for compound interest is:
I = P x r x t
I is the interest in dollars, P is the principal in dollars, r is the interest rate expressed as a decimal and t is the time period in years.
Say you have $100,000 on deposit, at an interest rate of 2% for the sake of simplicity. In your first year, you would earn $2000 if your interest period was 12 months. If you reinvest that interest, or allow it to compound, you would earn 2% on $102,000 in the second year, or $2040, so you would have $104,040.
Each year you earn 2% on the new balance, which is higher than the previous year.
With interest rates so low, this may not seem like a big gain, but when rates are higher, or you are working over a 5, 10 or even 20 year period, it can make a huge difference.
Another thing to consider is the interest period. Applying the interest quarterly, or monthly, can make a difference to the ultimate outcome, as you are earning interest on a higher amount every month or quarter rather than every year.
In our example above, if your interest was credited monthly, over a five-year period you would be over $500 better off. And again, if interest rates were higher, so would that difference be.
Unfortunately, the same works in reverse. Whatever debt you have, say on your credit card or mortgage, you pay interest on the principle, and on whatever additional interest has accrued
The interest rate on credit cards is much higher than on deposits. While rates vary from provider to provider, currently the average rate is 17%[i]. So if you have a credit card debt of $1000 at a rate of 17% annually, in the first month you will be paying $14.20 interest.
It gets complicated from here because most cards have a minimum payment, and each provider has different interest free periods and other conditions, but you get the gist. Next month you will be paying interest on $1014.20 and so on.
As you can see, this adds up very quickly and is one of the worst offenders for leakage in your financial plan. One of the best things you can do is make sure you pay your credit card off in full every month. If that’s just not possible, shop around for the best rate as there can be a difference of over 10% between one card and another.
If you would like advice on how to make compound interest work for you rather than against you, Manly Financial Services have the knowledge and experience to give you the right advice. Give us a call on (02) 9876 3388 or click below for an obligation free chat.