How to compute an annual compound interest rate
When it comes to personal finance, few concepts are as important to understand as compound interest. Many consumer finance products use this form of interest. Knowing about compound interest can save you from a potential bankruptcy.
The process of adding interest to principal is called compounding. Depending upon the type of personal loans, student loans, mortgages or other loans in question, interest is compounded on a regular schedule, be it daily, monthly, etc. Keep in mind that once compounding begins, interest itself earns more interest. This is a credit card company’s bread and butter, an easy way for a consumer to fall rapidly into debt. To understand the true cost of any credit card or loan, interest-related factors like how often the remaining balance is compounded and the annual percentage rate must be considered.
Compound interest should not be confused with simple interest. Simple interest is charged on principal balance only and doesn’t charge interest on accrued interest as compound interest does. Simple interest is quite rare in the field of consumer finance.
Doing the compound interest math
Here’s the math you need to know, using hypothetical numbers:
- Divide interest charged by the amount you owe to produce the periodic interest rate. If you are dealing with personal loans in the amount of $3,500 and you’re paying $25 monthly in interest, divide $25 by $3,500 to get 0.0071428571428571.
- Take the answer from the previous step and add 1. Now you have 1.0071428571428571.
- Raise the result of Step 2 to the exponential power of the number of payments you make on the loan or credit card each year. If you pay monthly, you make 12 payments per year. Using the same figures, the result is 1.089163111.
- Subtract one from the result in Step 3, which converts the compound annual interest rate to a decimal. Here, you have 0.089163111.
- Multiply the personal loan compound annual interest rate you changed into a decimal number by 100 to create an easy-to-read percentage. Here, you’d take 0.089163111 and multiply by 100 to produce an annual compound interest rate of 8.92 percent.