While some might argue that compound interest is the most powerful force in the universe, it is undoubtedly one of the most powerful financial forces on Earth. Understanding how compound interest works and how it applies to your student loan payment formula or your savings account could be the key to long-term financial success.
Whether you are borrowing money for student loans, purchasing a home or investing your savings, the power of compounding has a huge effect on your money. Here are four step to understanding this key law of finance:
Meet the compound interest formula
We all know interest is simply a percentage of funds paid to a borrower or lender. With compounding interest, you can continue to earn, or pay, interest on prior interest after each compounding period. In most cases, you will find that interest compounds monthly.
That’s where the compound interest formula comes in.
Learn the power of compound interest
The compound interest formula is not easy for everyone to follow, so let’s take a look at another example.
This time, we will look at someone saving in a retirement account. Let’s say a 22-year-old recent college graduate earns $40,000 per year and is saving 10% of their salary, or $4,000 per year.
In this case, our saver is putting in $333 per month and earning a 6% return, compounded monthly.
At the end of year one, this person would have contributed $4,000, but has $4,108 saved thanks to monthly compounding. After another year, the ending balance is $8,469. In just two years this person has over $500 in compounded interest earnings.
But saving for retirement is not a one- or two-year process. It takes place over decades. That’s the secret sauce of the compound interest formula.
In 10 years, this person’s balance is $54,572. After 20 years, it’s $153,860, of which more than $70,000 came from interest. At 30 years, the balance is $334,504, with over $200,000 from interest. And in 40 years when this person is 62 years old, the balance is $663,166, of which nearly $507,000 came from interest.
When you think about it, that is spectacular. Putting away $160,000 over 40 years, you end up with $663,000. That is a huge return on investment. All it takes is a significant amount of time for the compound interest formula to really make an impact.
That’s why starting young and contributing regularly to a retirement account is so important.
Simple Savings Calculator
Our Simple Savings Calculator can calculate the compound interest you’ll earn. Enter the starting balance of your account as the loan amount. Your monthly contribution will be the monthly loan amount, and then the expected annual return is the interest rate.
Know how compound interest and student loans interact
Interest compounding not only occurs with bank accounts, but it also happens on loans as well. It just works a little differently.
Interest compounds the same way with a principal balance. However, since borrowers make regular payments, the principle goes down each month. Simultaneously, the accrued interest goes down as well.
The process of calculating compound interest on a loan with a fixed payment each period is called amortization. Using amortization tables or calculators, you can see how much interest is paid over the life of the loan, assuming only the minimum loan payments are paid.
However, if you’re interested in seeing how much money you can save by making extra monthly payments on a student loan, or how much interest you’re actually paying your lender, check out the Student Loan Hero payoff calculator below.
Use this knowledge to get out of debt and save
Just as compound interest on savings and investments can make you rich, knowing how the compound interest formula works with loans can save you thousands of dollars. The power of interest is one of the most important forces in your finances, and shouldn’t be taken lightly.
Don’t sit back and let compound interest determine your financial fate. Take control and use compound interest to your advantage. It can completely change your financial future in a positive way.
Pay off your debt, save aggressively, and watch your net worth begin to climb. That’s harnessing the power of compound interest.
Christina Majaski contributed to this report.
Interested in refinancing student loans?
Here are the top 6 lenders of 2020!