When you first start investing, the calculations and options can feel overwhelming. However, breaking them down and making your decisions one at a time can help you manage and grow your money. One of the important decisions you must make about your savings account is how often to compound the interest. This can mean a difference of thousands of dollars in the long run, so it's important to take the time to understand your options now.
How Does Compounding Work?
Simply put, compounding interest is when your interest money earns interest too. If that sounds like magic to you, you're not alone. To understand how it works, think about an initial investment of $2,000 and an interest rate of 4 percent. Once the investment has been there for a year, you will have $2,080 in the account because you earned $80 in simple interest. Compounding interest builds on that $80.
In this example, assume that you compound the interest every year. When the account is two years old, you will earn interest on $2,080 instead of just the initial investment. That's $83.20 instead of the first year's $80. The next year, you'll earn interest on the initial $2,000, the $80 and the $83.20. This goes on and on until you close the account.
Formulas to Know
While annual compounding is a common option for investments, it is not the only way to compound your interest. In some cases, it may be more beneficial to compound your interest semi-annually, monthly or even daily. To determine which makes sense for your investing strategy, you may want to brush up on your algebra.
The main formula you need to know to calculate compounding interest is A = P (1 + r⁄n )^nt. In this formula, "P" represents the initial investment, "r" is the interest percentage expressed as a decimal, "t" represents the number of years you intend to use the account, "n" is how many times you compound the interest each year and "A" represents the final amount you will have when you close the account.
If you know all of these numbers except for one, you can calculate to find that number. For example, if you know how much you will deposit every year, the amount at which you want to end and your interest rate, you can use this formula to decide how often you need to compound the interest.
Tools to Help
If you're not great with math or just not confident enough to risk your savings on it, that's fine. There are several online calculators that can do this work for you. Reputable sources like MD Financial Management, AARP and NerdWallet have calculators that you can use. Enter the fields you know and try out different figures in other fields to see what works for you.
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