Calculating interest allows you to plan for important goals and understand your progress towards those goals. This page will cover how to calculate the following:
- Simple interest
- Single (one-time) investments
- Compound interest
- Ongoing (monthly, for example) investments
How to Calculate Interest You Earn
Interest is the cost of money. When you lend money or deposit funds into an interest-bearing account, you typically get your money back plus a little bit extra. That extra amount is interest, or your compensation for letting somebody else use your money. To calculate the interest following pieces of information:
- The amount of your deposit or the amount you lend, using the variable “P” for principal.
- When interest is calculated and paid (yearly, monthly, or daily, for example), using “n” for the number of times per year.
- The interest rate, using “i” and the rate in decimal format.
- How long you’ll earn interest for, using “t” for the term (or time) in years.
Example: Assume you deposit 100 at your bank, you earn interest annually, and the account pays 5 percent. Using the simple interest formula, interest amount (I) is
P x r x t = I
100 x 5 percent x 1 year = 5
100 x .05 x 1 year = 5
This calculation works when your interest rate is quoted as annual percentage yield. If your bank calculates interest monthly and adds earnings to your account monthly, as many banks do, a simple interest calculation is not accurate.
Calculate Compound Interest
Compounding happens when you earn interest, and then you earn even more interest on the interest earnings you previously received. To calculate compound interest on a savings account, your formula needs to take two things into account:
- More frequent periodic interest payments into the account, instead of one annual payment. For example, your bank might pay interest monthly.
- An increasing account balance that subsequent interest calculations are based on
Formula for compound interest to calculate the ending amount (A):
A = P (1 + r/n) ^ nt
Where “A” is the final amount, “P” is the principal, “r” is the interest rate, expressed as a decimal, “n” is the number of compounding periods per year, and “t” is the time period in years. Caret (^) is for exponentiation, which means a number is raised to the power of another.
For example, let’s say that you’re investing 20,000 at 5% interest, compounded quarterly, for 20 years. In this case, “n” would be four, since quarterly compounding occurs four times per year. From this information, we can calculate the investment’s final value after 20 years like this:
A = 20,000 (1 + 0.05 / 4) ^ 4 * 20
Calculate Monthly Interest
To calculate a monthly interest rate, divide the annual rate by 12 to account for the 12 months in every year. You started with one annual time period, and you’re looking for 12 monthly periods. The same concept can be used with other time periods:
- For a daily interest rate, divide the annual rate by 365
- For a quarterly rate, divide the annual rate by four.
- For a weekly rate, divide the annual rate by 52.
Example: Assume you pay interest monthly at 10 percent per year. What is your monthly interest rate and how much will you pay (or earn) on Rs 100?
- Convert the annual rate from percentage to decimal format (by dividing by 100)
10/100 = 0.1 monthly - Divide the annual rate by 12
0.10/12 = .0083 - Calculate the monthly interest on Rs 100
0.0083 x 100 = 0.83