How Interest Is Calculated? The power of compound interest


Interest is a very important variable in both the economy and the financial markets.

And the fact is that interest affects many areas of your life such as your savings, investments, business, retirement, credits, the cost of education, and even the purchasing power of your salary.


When you approach the bank and ask for a loan, you will have to pay an interest; instead the bank will pay you an interest if you open a savings account or CD, and your final decision will depend largely on the interest, because if the bank pays you a 5% rate for your savings, and there is an investment opportunity With a potential gain of 8%, the safest thing is that you will opt for the latter, as long as your risk tolerance allows it.

How Interest Is Calculated? The power of compound interest

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How is interest determined?

In the United States, the interest rate is set by the central bank known as the Federal Reserve, being at the same time the most important central bank since the dollar being the main reserve currency worldwide, any decision taken by this institution will affect the international markets.

Although the ideal is that interest is determined by market forces such as the supply and demand of money, and thus avoid distortions in the economy such as the well-known financial bubbles.


Interest calculation methods

As a saver, investor or loan applicant it is important that you know the difference between simple interest and compound interest. These are two very different methods of calculating interest that can have a big impact on your finances.

Simple interest

If you save at a simple interest rate you only earn interest on the principal.

For example, if you approach the bank with $ 1,000, and it offers you 10% annual interest, in the first year you will accumulate $ 100 in interest, in the second year you will accumulate another $ 100, and in the third year you will add $ 100 more in interest. In other words, after three years you will have $ 1,300.

The formula is very simple and is:

Interest = Principal x rate x time in years

If the time is given in months or days, it must be prorated. But do not complicate your life doing calculations since nowadays you can use calculation tools available on the internet.

How Interest Is Calculated? The power of compound interest

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The power of compound interest

Albert Einstein said that compound interest is the greatest mathematical discovery of all time, and it is not by chance that this is the most used method to calculate interest in the vast majority of consumer loans, and consists of accumulating interest not only in the main, but also in the interest earned in each period.

The key is to know how often interest is capitalized, and it can be monthly, quarterly, semi-annual, or annually. In some cases, they are capitalized daily.

For example, if you save the same $ 1,000 at a rate of 10% that is capitalized annually, it means that in the first year you will accumulate $ 100 in interest, in the second year you will accumulate $ 110, and in the third year you will accumulate $ 121. At the end of three years you will have a total of $ 1,331; that is, $ 31 more than if you had placed it at a simple interest rate.

The formula is a bit more complex but you can calculate it using the tools available in Excel or internet.

Nominal Rate vs. Effective rate

When compound interest is used, it is important to differentiate between the nominal rate and the effective rate. At the nominal rate it is commonly referred to as the annual interest rate or APR.

But in some cases the annual effective rate is advertised, and this depends on the frequency with which interest is capitalized in the year. For example, a nominal rate of 18% whose interest is capitalized quarterly is equivalent to an effective rate of 19.25%.

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