One more count of dollars and cents earned in a year on money in an account, can, when added to the money in the account, make the money grow larger. The pay off is worth it in the long run. As a rule, interest always raises up the account balance.

Compound interest makes the choice to put money in an interest earning account count for a lot because the interest always keeps on earning more interest. It might sound challenging. But, the steps used to calculate the interest are simple enough for anyone to do on their own.

1. Start with an amount of money that is not too much to put into an account for years. Make the money count big enough to pay off over the long run.

A $100 amount is a good amount to put away in a savings or checking account that earns interest, in bonds, or even in a retirement plan (such as an IRA or 401(k)). Americans that plan on earning more money choose stocks. All the accounts earn compound interest.

2. Know the interest rate for the account. The earnings rate is the key to knowing how the money grows. If the rate is not on the paperwork, ask the account representative for the rate. Write it down in a place it can be used to make calculations. Or, enter it in a spreadsheet (such as a financial plan sheet in Excel).

3. Calculate the interest the money earns in one year. The basic formula is simple. The principal, P1, in the account at year one equals the principal amount in the account at the time the first amount is put in the account, P0, plus that first principal amount times the interest rate, r.

The formula: P1 = P0 + (P0 x r).

The interest earned in one year is P0 x r.

4. If one year is not long enough to know how the money grows, use steps to calculate the total money in the account, with all the interest, in later years. Take a careful look at the amount in the account after 2 years, 5 years, or even 10 years.

The average money investor might want to avoid the complex formulas used to calculate the money in the account in a later year and the interest earned. Calculate each year one at a time.

The formula steps:

P1 = P0 + (P0 x r)

P2 = P1 + (P1 x r)

P3 = P2 + (P2 x r)

P4 = P3 + (P3 x r)

P5 = P4 + (P4 x r)

For example, $100 grows at 2 percent compound interest for five years.

P1 = 100 + (100 x .02) = $102.00

P2 = 102 + (102 x .02) = $104.04

P3 = 104.04 + (104.04 x .02) = $106.12

P4 = 106.12 + (106.12 x .02) = $108.24

P5 = 108.24 + (108.24 x .02) = $110.40

That is the original $100 and $10.40 interest earned in 5 years.

Use the steps to review investment growth or plan future finances. Five years is long enough to see a difference in how much the money grows. If there is time, try calculating 10 years and 20 years. The dollars and cents start to count up to a lot.

And try a larger amount. A $1,000 investment produces bigger earnings. A $10,000 investment can earn enough to pay for some of the living costs during retirement or pay for fixing up the house.

5. Subtract out the interest earned each year. Finding out the exact dollars and cents the interest earnings growth produced each year tells an investor exactly how much money their investment can earn over the years.

After going through the steps for later year calculations, for each interest earnings year, subtract the previous year total from the year total.

Interest earned during the year equals the amount in the account at year end, P for the year, minus the amount in the account at the end of the year before, P for the previous year (Py).

The formula: I = P - (Py). I is the interest earned in 1 year.

I1 = P1 - P0

I2 = P2 - P1

I3 = P3 - P2

I4 = P4 - P3

I5 = P5 - P4

Returning to the example of $100 that grows at 2 percent compound interest for 5 years.

I1 = 102.00 - 100 = $2.00

I2 = 104.04 - 102 = $2.04

I3 = 106.12 - 104.04 = $2.08

I4 = 108.24 - 106.12 = $2.12

I5 = 110.40 - 108.24 = $2.16

Notice that the interest earned is larger the second than the first, $2.04 compared to $2.00. That is compound interest. The 2.16 earned the fifth year is more than the interest earned the fourth, third, second, and first years. The interest earned always increases.

Tip. A money investor can calculate the interest earned on an account that they make regular investments in by using a more complex formula.

The basic formula: P1 = P0 + (P0 x r) + I1 + (I1 x (r x t)).

I1 is the amount invested during the year. t is the percentage of the year the investment was in the account (for example, an investment made on the first day in the tenth month was in the account three of twelve months or .25 of the 1 year).

Note. For the basic formula, the assumption is interest compounds annually. For example, an account with 2 percent interest rate will earn 2 percent at the end of one year. Interest compounded monthly or quarterly takes a more complex formula to calculate, though it is very similar.

Source:

U. S. Labor Department, Savings Fitness: A Guide To Your Money and Your Financial Future (October 2010).