How to calculate Compound Interest: discover the golden tip to use it in your favor!
Compound interest is that in which the monthly interest is incorporated into the capital. With such a rate, the amount grows much faster than with simple interest. In the case of a debt, it is dangerous. In the case of an investment, it is excellent. Find out all about compound interest!
One of the secrets to the operation of an investment strategy involves compound interest. It is through the consistent application of this rate that your equity can be multiplied, leading to the achievement of the defined objectives.
To take advantage of the mechanics, however, it is necessary to understand what these interests are, which investments they influence and how to favor their application. Thus, there is a chance to take your equity to another level.
In this post, you will understand everything about the subject and even have a simulation of how much a small monthly effort translates into 5, 10 and 20 years of investments. In practice, the final return is better than you can imagine.
Were you curious? So let’s go. Keep reading!
What are interest?
Interest is the consideration for lending money (or another item) to a person or institution. They are represented by a percentage of the total amount and can be calculated in a simple or compound way.
That is, the borrower receives a sum that he can allocate to the use that suits him. Meanwhile, the creditor earns an income for not having that value or item for use until they receive it back.
In practical terms, when you buy a Treasury Bond, for example, you are investing in government debt. It finances itself in this way: for being a good payer, the Government captures its invested resources and, in exchange, rewards it with compound monthly interest.
Thus, not using the money now in a purchase has an advantage: in a while, this economy may yield better acquisitions, because of the incidence of interest.
What is Compound Interest?
what-is-compound-interest
Compound interest is that in which the monthly interest is incorporated into the capital. With such a rate, the amount grows much faster than with simple interest. In the case of a debt, it is dangerous. In the case of an investment, it is excellent.
In both scenarios, debt and investment in financial institutions, the calculated interest is always compounded. An example of applying this type of interest is on the credit card bill.
By not paying it in full, the value may increase considerably in the next month due to the continued incidence of this interest. However, it is also possible to focus on compound interest that works for you and that can contribute to a more peaceful financial life.
For that, in addition to reading this post carefully, don’t forget to control your finances on a monthly basis. First, resolve the issue. Afterwards, seek your independence from investments in which interest rates are your allies.
Difference between simple interest and compound interest
The basic difference between simple interest and compound interest is the basis for calculating the rate. In simple interest, the rate is applied only on the initial amount.
In compound interest, it is applied to the last month’s amount (accumulating the effects of previous interest). That is, in the latter case, the value grows exponentially. This is called interest on interest.
Let’s take an example of a loan of R$ 10,000, considering a monthly rate of 1%. In the case of simple interest, the amount owed increases by R$100.00 (1% of R$10,000.00) each month. In 12 months, the total will be R$ 11,200.00.
In the case of compound interest, the amount owed increases by BRL 100 in the first month (1% of BRL 10,000.00), BRL 101 in the second month (1% of BRL 10,100.00), BRL 102.01 in the third month (1% of BRL 10,201.00) and so on. In 12 months, the total will be R$ 11,268.25.
Did you notice the difference? The value grows more with compound interest. And they are the ones you can count on to make your assets pay off with the right investments. In the long term, the divergence is very significant.
What is compound interest used for?
As you have seen, the payment of interest is intended to remunerate those who grant funds to be used by others, such as investors. In addition, they help to cover the existing credit risk, in view of the possibility of non-payment.
In compound interest, specifically, one of their functions is to increase equity exponentially. Considering that the incidence is on the amount that already accumulates the previous income, the rate accelerates the accumulation of values.
Therefore, they are important financial market instruments. After all, they act to remunerate investors in different classes of assets and financial products.
How does compound interest work on investments?
You can have good or bad experiences with interest. If you go into debt, you may find yourself facing a high incidence of compound interest, which will jeopardize much of your hard work.
But if you handle your money carefully and invest your savings in profitable investments, compound interest will make you better off financially in the future.
Have you ever heard of people who live on income or live on interest? This is compound interest in practice. Month after month, for a long time, investors allocated part of their reserves to an asset within their investment portfolio.
For example, a Direct Treasury bond or shares in investment funds. Over time, the power of compound interest multiplies your money with ever-increasing force. The longer the term, the greater the volume of resources invested — and the greater the interest work.
You will see, with the examples in the next topics, how to use this financial instrument to have a more peaceful future for your family. For that, a warning right now: you need to start setting aside a monthly amount, even if it’s small, and apply it rigorously every month.
What is the formula for calculating compound interest?
To really understand the impact of compound interest, it’s worth using the formula that allows you to perform the calculation. She is as follows:
M = C (1+i)^t, where:
M = amount obtained at the end;
C = invested capital;
i = monthly or annual interest rate;
t = interest application time in months or years, depending on the rate.
In addition to using this formula directly, you can take other paths to arrive at the calculation. Check out!
Practical example of how to calculate compound interest
Although you already know the formula, using it is not the only way to know the values. It is also possible to check the compound interest with the help of the calculator, especially if the time is shorter.
Think, for example, of an amount of R$ 1000.00, with compound interest of 4% per year. At the end of the period, the amount will increase to R$ 1040.00. In the following year, the 4% is levied on the R$ 1040.00, generating a new balance of R$ 1081.60. In the third year, the final amount will be R$ 1124.86.
When calculating the difference between the years, you will notice that each period the value of the yield given by the interest becomes larger. This is exactly the mechanics of compound interest. You can also use their compound interest calculator on a daily basis.
It will only be necessary to convert the monthly or annual rate, if applicable, into a daily rate. Interest of 4% per year, for example, corresponds to 0.0109% daily. Then, you will need to apply this percentage to do the calculations and figure out the daily compound interest payment.
Example of how to calculate compound interest in Excel
You have just seen compound interest exercises using the calculator. However, if the application takes place over a long period of time, it will be necessary to make successive calculations, right? So, to simplify, the tip is to use an Excel spreadsheet and automate the calculation.
To do this, you must place the main values of the formula in separate cells. In A1, for example, include the principal that will pass through interest income. In A2, include the interest rate amount. In A3, present the term, in months or years, depending on whether the fee is monthly or annual.
Then, in A5, enter the formula:
= A1*(1+(A2/100))^A3
The result will be the final amount, including the interest rate yield. Just save the worksheet to be able to change the values as you like and find the result of new situations in seconds.
How to Use a Simulator to Calculate Compound Interest
If you want to be even more practical, you can choose an alternative other than the calculator and the spreadsheet. Instead, you can use a simulator to calculate compound interest and understand how much your investment will yield.
When using this tool, use the BTG Pactual digital investment (and compound interest) simulator. Much more than just doing calculations, you will be able to discover your investor profile, which are the recommended investments and what their results may be.
Practical and efficient, right? Thus, you will learn about the performance of different investments, you will know what the likely scenarios are and you will understand how compound interest favors the accumulation of capital.
Why start investing?
The main reason people don’t invest early is that they think they don’t have enough money to start. And this is the biggest mistake: there is always a way to start saving a little and allocate part of the savings to investments.
Even if you start with $100.00 or $200.00, it’s important to apply a discipline of saving as soon as possible so that compound interest can work for you. It’s amazing the difference they make over a long period of time.
In order to take advantage of a longer period of interest application, it is therefore advisable to start as soon as possible. This favors a greater accumulation of equity, which helps to make the incidence of compound interest even more relevant — and your effort becomes smaller.
Investments that use compound interest
investments-that-use-compound-interest.
All investments available in the fixed income financial market use compound interest. For example, there is the CDB (bank deposit certificate), the LCI (real estate letter of credit), the LCA (agribusiness letter of credit), the Direct Treasury, savings accounts, among others.
The stock exchange, while not paying interest directly on investments (in stocks, for example), also offers compound returns. Therefore, in practice, any investment, whether in fixed or variable income, offers compound income.
An important observation concerns savings, which offer profitability in a very peculiar way. Instead of remunerating the investment daily (as many imagine), the application pays the income only once a month, on the anniversary of the deposit.
This means that an unsuspecting investor can withdraw all his savings from one hour to the next without realizing that the last month’s interest would only be credited the next day, for example.
Anyway, what should be clear is that all investments offer compound interest, which benefits the investment in the long term. So the longer you let your money go, the better. Preferably, in more advantageous options than savings.
But it is good to do this according to an investment strategy that considers diversified investments, both in fixed and variable income.