How to Calculate Compound Interest

Compound interest is calculated on a principal sum, which is a sum of the principal amount and the initial interest on that amount. Simply put, the interest is compounded to the original sum.

If a loan on an amount of USD 100 is to be repaid at 2 percent interest at the end of the first month, the total amount to be returned would be USD 102. If the compound interest on this sum is to be collected after a period of 2 months, the principal on which the total amount due to be paid will be USD 102.

In this case, the earlier interest of 2 percent is said to be 'compounded' to the principal amount. At the end of two months, the total amount due will be USD 104.04, as a new interest of USD 2.04 will be added to it.

Compound interest can be calculated as per the norms laid down by the condition of the respective agency or institution. For example, if you want to borrow a loan from a bank, then you will have to consider the loan interest that will have to be paid for the borrowed amount.

In fact, the compound interest on an amount happens to be the most useful of all the data available on that particular transaction.

Compound interest calculators are available on many websites. Additionally, it can also be calculated manually by applying mathematical formula. It is very important to understand the functioning of compound interest and relevant financial terms in order to get the best finance deal.

The rate of interest and the period for which it is valid are the two main areas of concern while considering a standard sum. Compound interest is the best measure to consider and compare different options and feasibility of a given deal in accordance with your needs.

The standard practice is to consider the rate on an annual term referred to as the effective rate of interest, annual percentage rate, or simply annual rate. It can also be converted to a standard base to compare the rates of different annual rates.

The mathematical formula for the calculation of the total amount (A) based on a certain rate of compound interest calculated (R) for a specified time period (n) is:

A = P × (1 + R/100)ⁿ

This equation gives the value of the amount accrued at a particular rate of interest on a certain principal value (P) over a fixed duration. The formula for calculation of compound interest follows logically, which is given below.

Interest = A − P

Thus, the interest amount in this case itself serves as a principal to garner furthermore interest.

There are various derivations based on the given formula, which bring out the suitability and application of compound interest in versatile situations. At times, compound interest is calculated on half-yearly basis, instead of yearly basis. In this case, the time period in calculation doubles and the rate becomes half.

A = P × (1 + R/200)^{2 × n}

Similarly, for a quarterly calculation, the time is increased by four times and the rate is decreased by one-fourth the actual figure. The same formula can be modified accordingly. The formula for interest in each case remains, the same which is: Interest = A − P