The 10 compound interest examples in this article give you the basic to intermediate knowledge to utilize compound interest to grow your wealth.
What is Compound Interest?
If an investor puts $1,000 into an investment that earns 5% annually, that investment will pay $50 in year 1.
The calculation is the same whether you start with $0.01 or $1 billion. But it only compounds if you reinvest the earnings (or hold for capital appreciation).
Why Compound Interest is Important
For the first example above, think of it as an interest-bearing savings account (if you can dream of one paying 5%).
In the real world, scenarios are far more complicated because investment values fluctuate by the second, and our savings and new investments change based on income and spending.
A hypothetical constant interest rate that would be required for compound interest to turn a given present value into a given future value in a given amount of time.
Calculating an investment portfolio's future value allows us to estimate our retirement date and future financial needs. It's critical to financial planners and DIY investors.
The Compound Interest Formula
We'll use basic math to demonstrate compound interest first. If this gives you scary high school flashbacks, skip to the next section for the spreadsheet version.
Where: A = the accrued amount P = the initial principal r = interest rate (expressed as a decimal) n = number of compoundings per year t = total number of years (time)
The Free Compound Interest Spreadsheet
This article steps you through ten calculations, starting with the compound interest formula, then building a series of compound interest examples to demonstrate variations.
I use a 4-year time period for the first group to explain the calculations, then expand to a 40-year horizon and add a few charts to show the magic of compound interest.
Having a spreadsheet will help you understand each calculation that I've screen-captured, and let you play with the numbers and experiment with your own scenarios.
Compound Interest Examples
Note: The examples in this article are all included in the free companion compound interest spreadsheet. Download it now and follow along, or wait until the end to experiment yourself.
If the above compound interest formula looks familiar to some of you, it's the Future Value (FV) function in Excel. Those of us who studied Finance in college are all too familiar with it.
Here's how I calculate compound interest in a spreadsheet using the same values. From here on, I set aside the parameters on the left side and build the table from the parameters.
When the compounding occurs more frequently, the Future Value of an investment increases, because the interest paid adds to the principal sooner, earning more interest along the way.
If you've heard of the term front-loading retirement accounts (contributing the IRA max in early January), this explains why the practice optimizes returns.
Compounding frequency varies depending on the investment. CAGR is annual, high-yield savings accounts compound daily, dividends are quarterly or monthly, and bonds usually pay out semiannually (and you must reinvest the interest to get the compounding effect).
Next, we'll look at how to calculate compound interest at different frequencies for the same above example to see how it changes the outcome.
Over the same 4-year period, if we choose to compound the initial $1,000 investment quarterly, or 16 times instead of four times over four years, we end up with $1,. That's a few dollars higher than the annual compound interest example.