My recent article in Decoded Science, “How to Calculate Compound Interest“, explains the straightforward math for calculating compound interest. It links to reference sites, including an online compound interest calculator tuned for American credit cards.
Just What is Compound Interest?
(Added Nov. 4, 2015). We can only answer “what is compound interest” by starting with simple interest.
“Simple interest” is the interest accrued to a principal amount. If $10,000 accrues 1% per month, the simple interest in one month is $100. The new balance is $10,100. After the second month, the simple interest is 1% of the original principal of $10,000, or $100 again. The balance after two months is $10,200.
“Compound interest” adds the interest accrued to the balance, in addition to the simple interest. Compound interest at 1% per month on a principal amount of $10,000 is also $100. That sets the balance at $10,100. However, the second month of interest applies to the total balance. So 1% of $10,100 is $101, and the final balance is $10,201.
Where Might Compound Interest Be Useful?
This Decoded Science article follows up my earlier “How to Calculate Simple Interest“.
Both types of interest calculation, simple or compound, affect our personal finances whether in a savings account or in our debts.
If you want to take charge of your personal finances, it’s absolutely essential that you understand the basics of how to calculate interest.
Whether you’re:
- Borrowing for a car loan
- Making a leasing arrangement for a vehicle;
- Getting a mortgage for your home;
- Opening a line of credit;
- Running a balance on your credit card;
- Investing in a savings account; or
- Buying a savings bond…
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Be sure to ask questions beyond “what’s the interest rate”?
When you owe money, ask whether they add the interest to the balance before or after your payment gets credited.
Ask how often the interest accrues. Do they calculate daily interest but only credit your savings account every month? On the daily balance or on the minimum balance during that period?
Beyond the calculated interest costs, loans and mortgages can have other traps. Can you make payments above those required in the repayment schedule? Will they be fully credited, or trigger an early payment penalty?
Here’s another example of an online credit card compound interest calculator I liked: “Why Make More Than The Minimum Payment?“.
Special Notes for Canadians to Minimize Credit Card Interest Costs
In Canada, consumer credit cards should not charge compound interest. If you decide to get an additional credit card from an American bank for your travel or business in the USA, ask about how they charge interest.
Normally a Canadian credit card does not charge interest at all on retail sales, provided you pay the balance in full by the payment due date. However, any cash advances (like taking money from a banking machine) or cheques written against the credit card account do indeed incur interest costs immediately. Once you carry a balance, the bank will charge interest on the retail balance also.
When you plan to make the last installment on a variable-payment loan such as a line of credit, ask for the “payout amount as of the payment date”. That should cover the final pennies of interest incurred through the end of the loan. Otherwise you might get another statement with a few cents as the balance, which is annoying.
Use any online compound interest calculator with a pinch of skepticism. They might apply the payment before or after the interest accrues; if that differs from your bank’s practice, it will make a subtle difference to your borrowing costs.
Learn More about Personal Finances than Simply How to Calculate Compound Interest
Once you know how to calculate compound interest, add more weapons to your arsenal for managing personal finances. Eric Tyson’s “Personal Finances for Dummies” (in the USA) is a paperback for those of us who must begin controlling our financial futures. Amazon’s customers rated it at 4.5/5 in 177 reviews, and that included a couple of financial advisors. Tyson’s “Personal Finances” book guides you through much more than just how to calculate interest with an interest rate formula.
Amazon Canada now offers “Personal Finances for Dummies” in Kindle format also.
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Thank you for reading about compound interest in Decoded Science.
Disclaimer: The information contained in this article is for educational purposes only. Any reader who is concerned about his or her financial health should contact an accredited professional advisor.
