3/18/2015

LearnSimpleAndCompoundInterest
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Learn Simple And Compound Interest

By Elvis Picardo, CFA

Interest is defined as the cost of borrowing money, and depending on how it is

calculated, can be classified as simple interest or compound interest. Simple
interest is calculated only on the principal amount of a loan. Compound interest
is calculated on the principal amount and also on the accumulated interest of
previous periods, and can thus be regarded as interest on interest. This
compounding effect can make a big difference in the amount of interest payable
on a loan if interest is calculated on a compound rather than simple basis. On the
positive side, the magic of compounding can work to your advantage when it
comes to your investments, and can be a potent factor in wealth creation. While
simple and compound interest are basic financial concepts, becoming
thoroughly familiar with them will help you make better decisions when taking
out a loan or making investments, which may save you thousands of dollars over
the long term.

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The formula for calculating simple interest is:

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Simple Interest = Principal x Interest Rate x Term of the loan

=Pxixn
Thus, if simple interest is charged at 5% on a $10,000 loan that is taken out for a
three-year period, the total amount of interest payable by the borrower is
calculated as: $10,000 x 0.05 x 3 = $1,500.
Interest on this loan is payable at $500 annually, or $1,500 over the three-year
loan term.

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Compound Interest

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The formula for calculating compound interest is:

Compound Interest = Total amount of Principal and Interest in future (or Future
Value) less Principal amount at present (or Present Value)
= [P (1 + i)n] P
= P [(1 + i)n 1]
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where P = Principal, i = annual interest rate in percentage terms, and n = number

of compounding periods.
Continuing with the above example, what would be the amount of interest if it is
charged on a compound basis? In this case, it would be: $10,000 [(1 + 0.05)3]
1 = $10,000 [1.157625 1] = $1,576.25.
While the total interest payable over the three-year period of this loan is
$1,576.25, unlike simple interest, the interest amount is not the same for all
three years, because compound interest also takes into consideration
accumulated interest of previous periods. Interest payable at the end of each
year is shown in the table below.

Compounding Periods
When calculating compound interest, the number of compounding periods
makes a significant difference. The basic rule is that the higher the number of
compounding periods, the greater the amount of compound interest. So for
every $100 of a loan over a certain period of time, the amount of interest
accrued at 10% annually will be lower than interest accrued at 5% semiannually, which will in turn be lower than interest accrued at 2.5% quarterly.
In the formula for calculating compound interest, the variables i and n have
to be adjusted if the number of compounding periods is more than once a year.
That is, i has to be divided by the number of compounding periods per year,
and n has to be multiplied by the number of compounding periods. Therefore,
for a 10-year loan at 10%, where interest is compounded semi-annually (number
of compounding periods = 2), i = 5% (i.e. 10% / 2) and n = 20 (i.e.10 x 2).
The following table demonstrates the difference that the number of
compounding periods can make over time for a $10,000 loan taken for a 10-year
period.

Associated Concepts
In this section, we introduce some basic concepts associated with compounding.

Time Value of Money

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Since money is not free but has a cost in terms of interest payable, it follows
that a dollar today is worth more than a dollar in future. This concept is known
as the time value of money, and forms the basis for relatively advanced
techniques like the discounted cash flow (DCF) analysis. The opposite of
compounding is known as discounting
discounting;; the discount factor can be thought of as
the reciprocal of the interest rate, and is the factor by which a future value must
be multiplied to get the present value.
The formulae for obtaining the
future value (FV) and present value (PV) are as follows:
FV = PV (1 +i) n and PV = FV / (1 + i) n
For example, the future value of $10,000 compounded at 5% annually for three
years:
= $10,000 (1 + 0.05)3
= $10,000 (1.157625)
= $11,576.25.
The present value of $11,576.25 discounted at 5% for three years:
= $11,576.25 / (1 + 0.05)3
= $11,576.25 / 1.157625
= $10,000
The reciprocal of 1.157625, which equals 0.8638376, is the discount factor in
this instance.

Rule of 72
The Rule of 72 calculates the approximate time over which an investment will
double at a given rate of return or interest i, and is given by (72 / i). It can
only be used for annual compounding.
For example, an investment that has a 6% annual rate of return will double in 12
years.
An investment with an 8% rate of return will double in 9 years.

Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) is used for most financial
applications that require the calculation of a single growth rate over a period of
time.
For example, if your investment portfolio has grown from $10,000 to $16,000
over five years, what is the CAGR? Essentially, this means that PV = -$10,000,
FV = $16,000, n = 5, so the variable i has to be calculated. Using a financial
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calculator or Excel spreadsheet,

spreadsheet, it can be shown that i = 9.86%.
(Note that according to cash flow convention, your initial investment (PV) of
$10,000 is shown with a negative sign since it represents an outflow of funds.
PV and FV must necessarily have opposite signs to solve for i in the above
equation).
Real-life Applications
The compound annual growth rate (CAGR) is extensively used to calculate
returns over periods of time for stock, mutual funds and investment
portfolios. The CAGR is also used to ascertain whether a mutual fund
manager or portfolio manager has exceeded the markets rate of return
over a period of time. For example, if a market index has provided total
returns of 10% over a five-year period, but a fund manager has only
generated annual returns of 9% over the same period, the manager has
underperformed the market.
The CAGR can also be used to calculate the expected growth rate of
investment portfolios over long periods of time, which is useful for such
purposes as saving for retirement. Consider the following examples:
1. A risk-averse investor is happy with a modest 3% annual rate of return on her
portfolio. Her present $100,000 portfolio would therefore grow to $180,611
after 20 years. In contrast, a risk-tolerant investor who expects an annual return
of 6% on his portfolio would see $100,000 grow to $320,714 after 20 years.
2. The CAGR can be used to estimate how much needs to be socked away to
save for a specific objective. A couple who would like to save $50,000 over 10
years towards a down payment on a condo would need to save $4,165 per year
if they assume an annual return (CAGR) of 4% on their savings. If they are
prepared to take a little extra risk and expect a CAGR of 5%, they would need to
save $3,975 annually.
3. The CAGR can also be used to demonstrate the virtues of investing earlier
rather than later in life. If the objective is to save $1 million by retirement at age
65, based on a CAGR of 6%, a 25-year old would need to save $6,462 per year to
attain this goal. A 40-year old, on the other hand, would need to save $18,227,
or almost three times that amount, to attain the same goal.
CAGRs also crop up frequently in economic data. For example, Chinas
per-capita GDP increased from $193 in 1980 to $6,091 in 2012. What is the
annual growth in per-capita GDP over this 32-year period? The growth rate
i in this case works out to an impressive 11.4%.
Points to consider
Make sure you know the exact annual payment rate (APR) on your loan,
since the method of calculation and number of compounding periods can
have an impact on your monthly payments. While banks and financial
institutions have standardized methods to calculate interest payable on
mortgages and other loans, the calculations may differ slightly from one
country to the next.
Compounding can work in your favor when it comes to your investments,
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but it can also work for you when making loan repayments. For example,
making half your mortgage payment twice a month, rather than making the
full payment once a month, will end up cutting down your amortization
period and saving you a substantial amount in interest.
Compounding can work against you if you carry loans with very high rates
of interest, like credit-card or department store debt. For example, a
credit-card balance of $25,000 carried at an interest rate of 20% compounded monthly - would result in a total interest charge of $5,485
over one year or $457 per month.
The Bottom Line
Get the magic of compounding working for you by investing regularly and
increasing the frequency of your loan repayments. Familiarizing yourself with
the basic concepts of simple and compound interest will help you make better
financial decisions, saving you thousands of dollars and boosting your net worth
over time.
To learn more about interest rates, check out What determines the interest rate
in my money market account?

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