The rate of return gets most of the attention when investors are looking at possible investments, but you should also take note of how often the interest is compounded because that could make an investment with a lower interest rate actually have a higher rate of return since interest is compounded more frequently. For example, if you are comparing different certificates of deposit, having interest compound semiannually versus just once at the end of a multi-year term could make a difference to your bottom line. To calculate semiannual compounding, you also need to know how much you’re investing and how long you’re going to leave your money in the specific investment.
Importance of Interest Compounding
Interest compounding refers to the impact of added accrued interest throughout the term of the investment. For example, if interest is compounded daily, that means every day a little more interest is added to the balance of the account, increasing the amount of interest the account accrues the following day. If interest is compounded annually, the interest that accrues on day one doesn’t start earning additional interest until a year later.
Semiannual Investment Return Formula
To calculate how much an investment that compounds semiannually will be worth in the future, start by dividing the annual rate of return by 100 to convert it to a decimal. Second, divide the annual rate as a decimal by 2 to calculate the semiannual rate of return. Third, add 1 to the semiannual rate of return as a decimal. Fourth, raise the result to the power of the number of half years you’ll retain the investment. Fifth, multiply the result by your initial investment to calculate what your investment will be worth after the specified time period. Finally, subtract your initial investment from what the investment will be worth to calculate how much your investment will increase.
For example, say that you are investing $2,500 in a three-year CD that pays 3.5 percent per year and compounds interest semiannually. First, divide 3.5 by 100 to find that the annual interest rate as a decimal equals 0.035. Second, divide the 0.035 by 2 to find that the semiannual interest rate equals 0.0175. Third, add 1 to 0.0175 to get 1.0175. Fourth, raise 1.0175 to the sixth power to get 1.109702354 because there are six semiannual periods in a three-year time span. Fifth, multiply 1.109702354 by $2,500 to find that your CD will be worth $2,774.26 when the CD matures at the end of three years. Finally, subtract the initial investment of $2,500 from $2,774.26 to find that you’ll have earned $274.26 in interest.
Items you will need
- Scientific calculator
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