Do You Know What a Compounding Interest Rate is?

Mundane pre-calculus math classes sometimes cover compounding interest rates. People commonly overlook it as a method to gain more money on as little as one dollar. We are talking about Compound Interest rates! Compounded interest rates have been placing academics in awe for a long time. As early as 1906, it was described as being one of man’s most remarkable inventions. Essentially, a compounded interest rate is one that gets compounded (added to) a certain amount of times throughout a calendar year. People also know it as “interest on interest”. Compounded interest rates are a way to better both corporations and personal income earners. For example, if you have one US dollar that will be compounded twice a year and earns a 10% interest rate then it would look something like this:

● $1.00 X 1.1(interest rate) = $1.10 (First compounding interest period)

● $1.10 X 1.1(interest rate) = $1.21(Second compounding interest period)

Now that you have a general idea of the theory behind compounding interest rates, let try a more difficult problem. But, we’ll use a handy formula.

Formula

FV = PV x [ 1 + (i / n) ] (n x t)

FV = Future value of your money

PV = Present value of your money

i = interest rate on your money

n = # of compounding periods/year

○ Yearly Compound= 1; Quarterly compound= 4; Daily compound= 365

t = # of years

How much would an original investment of $200 be worth if it were to be compounded quarterly for two years at an interest rate of 4% (.04)?

FV = PV x [ 1 + (i / n) ] (n x t)

FV = 200 x [ 1 + (.04 / 4) ] (4 x 2)

FV= 428.71

Make sure to check out our “Time Value of Money” article to learn more about this super important personal finance topic!

Lastly, you can also use this calculator.

¹ Garson. “Compound Interest Is Man’s Greatest Invention.” Quote Investigator. October 31, 2011. Accessed May 31, 2018. https://quoteinvestigator.com/2011/10/31/compound-interest/.

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