How do you calculate interest rates and how it can make you rich.

 

When investing, the displayed interest rate is often not the actual percentage that you will get. This simple hack can increase your wealth exponentially. How do you calculate interest rates is my quick guide to divulging the tricks all investors must know in order to slightly bend the balance to their advantage.

Simple interest investment

The simple interest rate is the easiest one to understand and to calculate. Let’s take a 10,000$ investment that has been invested for a period of 60 months (5 years) and has an interest of 10% per year as an example. With the simple interest, the interest is not calculated on top of the interest. Illustration:

Amount: 10,000$
Interest: 10% per year
Length of the investment: 60 months
Total interest: 10,000$* 10%=1,000$ * 5 years= 5000$
Total amount including interest: 15,000$ 

The quick formula to calculate the interest rate received on a simple interest investment is: FV=PV (1+r*t).
Where FV stands for: Future value of the investment or the value of the investment after a set period (Ex: 5 years).
PV is for: Present value of the investment or the value of the investment today.
r is for: Rate of return or rate of the investment and;
t is for: Length of time you will invest the present value.

Key takeaways of a simple interest investment

1. It’s calculated on the total principal amount for the entire duration.
2. The accumulated interest on the principal is not added to the calculation of the interest for the next period. Hence, no interest over interest compounding.
3. The interest earned will not increase even if the calculation is done using different periods.
4. The accumulation on interest will be slow.
5. It is beneficial if you take a loan but to your detriment if it’s for investing purposes.
6. It is simply not good for wealth creation.
7. Simple interest is the easiest to calculate.

Compound interest investment

Herein lays the magic trick. To compound the interest simply means to add the interest to the balance of the investment henceforth adding the interest amount on top of the previously added interest amount. To use a visual analogy, it’s like an avalanche. It starts slowly and with momentum, it quickly adds up. The more money you invest at a higher compounded rate, the faster you will reach your financial goal.

There are different compounding periods. The most common are daily, monthly, semi-annually and annually. If the compounding period is daily, it means that every day the daily equivalent of the yearly interest rate is added to the balance. To illustrate this mathematically, let’s take the same numbers and add a yearly compounding period and you’ll see how the final amount fluctuates.

Amount: 10,000$
Interest: 10% per year
Length of the investment: 60 months
Compounding period: Annually
Total interest year 1: 10,000$* 10%=1,000$
Total interest year 2: 11,000$* 10%= 1,100$
Total interest year 3: 12,100$ * 10%=1,210$
Total interest year 4: 13,310$ * 10%= 1,331$
Total interest year 5: 14,641$* 10%= 1,464$
Total amount including interest: 16,105$ 

The difference between the simple interest investment and the compound interest investment is a staggering (16,105$-15,000$) = 1,105$. This example only shows a small portion of the power of compounding. Increase the amounts and the length of the investment and the results will increase exponentially.

The quick formula to calculate the compound interest rate accumulated on an investment is: FV= PV (1+r) t
Where FV stands for: Future value of the investment or the value of the investment after a set period (Ex: 5 years)
PV is for: Present value of the investment or the value today of the investment
r is for: Rate of return or rate of the investment and;
t is for: Length of time you will invest the principal.

Key takeaways of a compound interest investment

1. It’s calculated on the principal amount periodically( annually, quarterly, semi-annually, monthly and even daily)
2. The accumulated interest on the principal is added to the calculation of the interest for the next period. Hence, interest over interest compounding.
3. The interest earned will increase in relation with the number of compounding periods. More compounding, more money for you.
4. The accumulation on interest will be faster because you accumulate interest on interest.
5. It is beneficial for investing purposes but to your detriment if it’s for a loan.
6. It’s the best for wealth creation.
7. It’s a bit more complicated to calculate.

Conclusion

By now, I hope I conveyed the importance of the power of compounding. In the case of an investment always ask the financial representative for the compounding frequency and choose the one with the highest frequency.

In the case of a loan, always ask the financial representative for the compounding frequency and choose the one with the lowest frequency.

In order to compare rates that have different compounding frequencies, it’s mandatory to use the effective rate. The effective rate is the key to deciphering any compounding frequency. Regardless of the compounding frequency, the effective rate will provide an equivalent interest rate. Click here, to be redirected to a calculator that will do the conversion for you. Input the nominal interest rate which is the advertised rate provided by the financial provider. Select the compounding frequency and click calculate. That’s it. Comparing different financial products have never been this easy.

If you want to learn more about how to calculate all types of interest rates and how it can make you money, The book of interest and money is a wonderful ressource.

Related article: I found the lowest interest loan in Canada for you.

Thank you for reading my article and don’t forget to leave a comment.

Brice

Savvyborrower.com

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