How to calculate Compound Interest: discover the golden tip to use it to your advantage!
Compound interest is that in which the month’s interest is incorporated into the capital. With a rate like this, the value grows much faster than with simple interest. In the case of debt, it is dangerous. In the case of an investment, it is excellent. Discover everything about compound interest!
One of the secrets to how an investment strategy works involves compound interest. It is through the consistent application of this rate that your assets can multiply, leading to the achievement of the defined objectives.
To take advantage of the mechanics, however, it is necessary to understand what these interests are, what investments they influence and how to promote their application. Thus, there is the chance to take your wealth to another level.
In this post, you will understand everything about the subject and will even have a simulation of how much a small monthly effort translates into 5, 10 and 20 years of investments. In practice, the final return is better than you can imagine.
Are you curious? So let’s go. Keep reading!
What is interest?
Interest is the consideration for lending money (or another item) to a person or institution. They are represented by a percentage of the total value and can be calculated in a simple or compound way.
In other words, the borrower receives a sum that he can allocate to whatever use suits him. Meanwhile, the creditor earns income by not having that value or item for use until they receive it back.
In practical terms, when buying a Treasury Direct bond, for example, you are investing in Government debt. It finances itself in this way: for being a good payer, the Government captures your invested resources and, in return, rewards you with compound monthly interest.
Therefore, not using money now for a purchase has an advantage: in the future, this savings will be able to yield better purchases, due to the incidence of interest.
What is Compound Interest?
what-are-compound-interest
Compound interest is that in which the month’s interest is incorporated into the capital. With a rate like this, the value grows much faster than with simple interest. In the case of debt, it is dangerous. In the case of an investment, it is excellent.
In both scenarios, debt and investment in financial institutions, the interest calculated is always compounded. An example of application of this type of interest is on credit card statements.
If you do not pay it in full, the amount may increase considerably in the next month due to the continued incidence of this interest. However, it is also possible to focus on compound interest that works for you and can contribute to a more peaceful financial life.
To do this, in addition to reading this post carefully, don’t forget to control your finances monthly. First, resolve the issue. Then, seek your independence through investments in which interest is your ally.
Difference between simple interest and compound interest
The basic difference between simple interest and compound interest is the basis for calculating the rate. In simple interest, the rate is applied only to the initial amount.
In compound interest, it is applied to the last month’s value (accumulating the effects of previous interest). In other words, in the latter case, the value grows exponentially. This is what is called interest on interest.
Let’s take an example of a loan of R$10,000, considering a monthly rate of 1%. In the case of simple interest, the amount owed increases by R$100.00 (1% of R$10,000.00) each month. In 12 months, the total will be R$11,200.00.
In the case of compound interest, the amount owed increases by R$100 in the first month (1% of R$10,000.00), R$101 in the second month (1% of R$10,100.00), R$102.01 in the third month (1% of R$ 10,201.00) and so on. In 12 months, the total will be R$11,268.25.
Did you notice the difference? The value grows more with compound interest. And they are the ones you can count on to make your assets pay off with the right investments. In the long term, the divergence is very significant.
What is compound interest for?
As you have seen, interest payments are intended to compensate those who grant resources to be used by others, such as investors. Furthermore, they help cover existing credit risk in the event of payment not occurring.
In compound interest, specifically, one of its functions is to increase wealth exponentially. Considering that the incidence is on the amount that the previous income already accumulates, the rate accelerates the accumulation of values.
Therefore, they are important financial market instruments. After all, they work to remunerate investors in different asset classes and financial products.
How does compound interest work in investments?
You can have good or bad experiences with interest. If you get into debt, you may find yourself facing a large incidence of compound interest, which will put a lot of your hard work at risk.
But, if you handle your money carefully and invest your reserves in advantageous investments, compound interest will be responsible for leaving you in a better financial situation in the future.
Have you ever heard of people who live off income or live off interest? This is compound interest in practice. Month after month, for a long time, investors allocated part of their reserves to an asset within their investment portfolio.
For example, a Treasury Direct bond or shares in investment funds. Over time, the power of compound interest multiplies your money with greater and greater force. The longer the term, the greater the volume of resources invested — and the greater the interest work.
You will see, with the examples in the next topics, how to use this financial instrument to have a more peaceful future for your family. To this end, a warning from now on: you need to start setting aside a monthly amount, even if it is small, and apply it rigorously every month.
What is the formula for calculating compound interest?
To really understand the impact of compound interest, it’s worth using the formula that allows you to perform the calculation. It is as follows:
M = C (1+i)^t, where:
M = amount obtained at the end;
C = invested capital;
i = monthly or annual interest rate;
t = interest application time in months or years, depending on the rate.
In addition to using this formula directly, you can take other paths to arrive at the calculation. Check out!
Practical example of how to calculate compound interest
Even though you already know the formula, using it is not the only way to know the values. It is also possible to check compound interest using a calculator, especially if the time is shorter.
Think, for example, of an amount of R$1000.00, with compound interest of 4% per year. At the end of the period, the amount will increase to R$ 1040.00. In the following year, the 4% applies to R$ 1040.00, generating a new balance of R$ 1081.60. In the third year, the final value will be R$1124.86.
When calculating the difference between years, you will notice that with each period the value of the interest income becomes greater. This is exactly the mechanics of compound interest. You can also use your compound interest calculator on a daily basis.
It will only be necessary to convert the monthly or annual fee, if applicable, into a daily rate. Interest of 4% per year, for example, corresponds to 0.0109% daily. Then, you will need to apply this percentage to do the calculations and discover the daily payment of compound interest.
Example of how to calculate compound interest in Excel
You have just seen exercises on compound interest using the calculator. However, if the application takes place over a long period of time, it will be necessary to make successive calculations, right? So, to simplify, the tip is to use an Excel spreadsheet and automate the calculation.
To do this, you must place the main values of the formula in separate cells. In A1, for example, include the capital that will pass through interest income. In A2, include the interest rate amount. In A3, present the term, in months or years, depending on whether the fee is monthly or annual.
Then, in A5, enter the formula:
= A1*(1+(A2/100))^A3
The result will be the final amount, including the interest rate income. Just save the spreadsheet to be able to change the values as you want and find the result of new situations in seconds.
How to use a Simulator to calculate compound interest
If you want to be even more practical, you can choose an alternative other than the calculator and spreadsheet. Instead, you can use a simulator to calculate compound interest and understand how much your investment will yield.
When using this tool, use the investment (and compound interest) simulator from BTG Pactual digital. Much more than just making calculations, you will be able to discover your investor profile, which investments are recommended and what their results could be.
Practical and efficient, right? This way, you will learn about the performance of different investments, you will know what the likely scenarios are and you will understand how compound interest favors capital accumulation.
Why start investing?
The main reason people don’t invest early is that they think they don’t have enough money to start. And this is the biggest mistake: there is always a way to start saving a little and allocate part of the savings to investments.
Even if you start with R$100.00 or R$200.00, it is important to apply a savings discipline as quickly as possible so that the compound interest can work for you. It’s amazing what a difference they make over a long period of time.
To take advantage of a longer period of interest application, it is therefore advisable to start as soon as possible. This favors a greater accumulation of assets, which helps to make the incidence of compound interest even more relevant — and your effort becomes less.
Investments that use compound interest
investments-that-use-compound-interest.
All investments available in the fixed income financial market use compound interest. For example, there is the CDB (bank deposit certificate), the LCI (real estate credit bill), the LCA (agribusiness credit bill), the Treasury Direct, savings, among others.
The stock market, although it does not pay interest directly on investments (in shares, for example), also offers compound returns. Therefore, in practice, any investment, whether in fixed or variable income, offers compound returns.
An important observation concerns savings, which offer profitability in a very peculiar way. Instead of paying back the investment daily (as many imagine), the application pays the income only once a month, on the anniversary of the deposit.
This means that an unsuspecting investor can withdraw all of their savings from one moment to the next without realizing that the last month’s interest would only be credited the next day, for example.
In any case, what should be clear is that all investments offer compound interest, which benefits long-term investment. Therefore, the longer you let your money earn, the better. Preferably, in options that are more advantageous than savings.
But it is good to do this according to an investment strategy that considers diversified investments, both in fixed income and variable income.
