How To Calculate Compound and Simple Interest

Once you know how to calculate compound and simple interest, you’ll see your finances in a whole new light.

Understanding how to calculate compound and simple interest is like possessing a financial compass—it helps you plan your financial goals and work towards them. 

Whether you’re just starting to think of retirement, burdened with credit card debt, or just want to understand how interest works a little better, this guide will show you how to calculate compound and simple interest, how interest benefits you, and what to do when it works against you. 

KEY TAKEAWAYS:

• The Power of Compounding — Compound interest accelerates the growth of savings over time. When you reinvest the interest earned, your money starts working for you, leading to exponential growth.
• The Dual Face of Interest — Interest is great for your savings, but can catalyze a debt spiral for borrowers. Mismanaged compound interest, especially on credit card debt, leads to financial burdens that are tough to overcome.
• Navigating Debt Strategies — Sometimes high interest debt gets out of control. Fortunately there are a number of strategies that can help you lower or eliminate your debt.

How Does Interest Work?

Interest is the cost of borrowing money. 

Lenders are incentivized to provide loans because they earn profit through interest accrued on the principal amount. This is how financial institutions, like banks, sustain themselves and grow.

Interest rates influence the true cost of major financial commitments like homes, vehicles, or any credit-backed purchase.

For example, say you take out a loan of $100 at an interest rate of 5%. Later, you repay the lender $105. You got money you didn’t have when you needed it and the lender profited $5. 

Simple vs Compound Interest

There are two main types of interest: simple interest and compound interest. You can use an interest calculator to find either type. Each has a distinct impact on the growth of your savings.

• Simple Interest — Interest generated solely on the principal amount, like the initial deposit of a savings account. 
• Compound Interest — Interest accrued on the principal amount plus previously accumulated interest. 

Think of compound interest as “interest on interest.” Over time, savings in an account earning compound interest will grow exponentially (ideally). 

How to Calculate Simple Interest 

To calculate simple interest, you multiply the initial amount of money (known as the principal), by the annual interest rate, then multiply the result by the number of years the money is invested or borrowed for. 

Simple interest is a good calculation to use if you’re just looking for a rough estimate of how much interest you’ll earn over time based on the principal. 

There are 3 variables to know when calculating simple interest:

• I is the total interest earned or paid.
• P is the principal investment/loan amount.
• r is the annual interest rate (as a decimal).
• t is the number of years the money is invested/borrowed for.

The equation for simple interest is:

• I = P x r x t 

Example of Simple Interest

Let’s say you put $5,000 dollars in a savings account. Interest rates in savings accounts are typically low, so we’ll say it’s 0.05%. 

Now we’ll plug in the numbers to estimate the total interest over 10 years (in this case “earned”):

• I = $5,000 x 0.0005 x 10

In this case, the total interest earned would be $25 over 10 years. Not too exciting right? But let’s take a look at compound interest. 

How to Calculate Compound Interest 

To calculate compound interest, multiply the principal by 1 plus the annual interest rate raised to the number of times interest is applied, then subtract the original principal to determine the interest earned over the specified period.

This sounds complicated, but after we write it out as an equation and work through an example, it will actually become quite simple. 

There are 5 important variables to know when calculating compound interest:

• A is the future value of the investment/loan, including interest.
• P is the principal investment/loan amount.
• r is the annual interest rate (as a decimal).
• n is the number of times interest is compounded per year.
• t is the number of years the money is invested/borrowed for.

The equation for compound interest is:

• A=P(1+r/n)^nt 

Example of Compound Interest 5%

Let’s say you start saving $5,000 per year at 20 years old. 

You put that money into a brokerage account and expect to earn an average 10% interest annually over the next 10 years. By the time you turn 60, that account should be worth about $2,212,963. 

A=$5,000(1+.101)(1)(40)

If you did the same thing, but waited until you were 30, that same account would be worth $822,470, about $1.4 million less. 

Now consider that $5,000 a year is only about $417 a month. This is the power of compound interest, and it’s why it’s so important to start saving early.

When Compound Interest Works Against You

Compound interest can quickly cause your finances to spin out of control if not managed carefully. 

Anyone who has used their credit card too loosely can understand this. We’ve looked at an example of how compound interest works for you, now let’s look at how it can work against you.

Imagine you have a credit card with a balance of $5,000 and an Annual Percentage Rate (APR) of 22%. 

If you make only the minimum payment each month, your balance won’t decrease quickly because a significant portion of your payment is going towards paying off interest. Over time, you end up paying much more than the original $5,000 due to the accumulating compound interest.

Let’s break this down. First, we’ll divide the APR by 12 to get the monthly interest rate: 

• 22%/12=1.83%

So, for the initial $5,000 balance, the first month’s interest would be:

• 0.0183 x $5,000 = $91.50 

Instead of the balance decreasing by the amount you paid, it decreases by the payment minus this interest. If your minimum payment was $120, only $28.50 (120 – 91.50) would go towards the principal. The rest is consumed by interest. 

As months progress, you’re continually charged interest on a balance that’s decreasing at a much slower rate than your payments. 

Fortunately, if you’re in a debt spiral like this, there are a few options:

• Debt Relief — This typically refers to partial or total forgiveness (elimination) of debt. Some companies might offer to negotiate with your creditors to reduce your owed amount. 
• Debt Consolidation — This is when you combine multiple debts into a single debt, often with a lower interest rate. 
• Debt Settlement — This involves negotiating with your creditors to pay a lump sum that’s less than what you owe.

Each option has its pros and cons, but they all make it easier to clear your debts. Make sure to speak with a debt specialist to learn which route is best for you. 

At Americor, we understand the importance of managing your finances wisely. 

If high-interest debts are impacting your savings and financial well-being, explore our debt relief solutions, including debt settlement and debt consolidation, to regain control of your financial future.

If your debt has become unmanageable and you have difficulty making your debt payments each month, then you should consider negotiating a debt settlement and an affordable payment plan that suits your budget.

Talk to one of our certified Debt Consultants, for free, who can provide personalized advice tailored to your specific needs.

By taking proactive steps, you can put an end to your financial stress and work towards a brighter financial future. Remember, there is always hope for debt relief, and our team of experienced professionals are ready to guide you on your journey to regaining control of your finances.

For more information about Americor’s debt relief services, contact us today to see how we can help you eliminate your debts, and get on the fast-track to becoming completely debt-free!