Compounding interest is where an investment will pay interest on both the initial principal and the accrued interest. To find the power of compounding, an investor should compare two sets of compounding. The first set is for a longer period of time, such as five years, and the second is for a shorter period, such as three years. The difference between the two sets shows the power of compounding.
Say an investor saves money in an account that compounds monthly, paying 6 percent interest per year for five years. The investor's initial deposit is $60,000. Divide the interest rate by the number of times a loan compounds per year. In our example, 6 percent divided by 12 months equals 0.005.
Add 1 to the interest rate per times compounded. In our example, 1 plus 0.005 equals 1.005.
Multiply the number of years the investment compounded by the number of times the investment compounds per year. In our example, 5 times 12 equals 60. This is the number of times the interest compounds over the entire life of the investment.
Raise the number calculated in Step 2 to the power of the number of times the investment compounds over its entire life. In our example, 1.005 raised to the power of 60 equals 1.34885. This is the compound interest factor.
Multiply the compound interest factor by the original deposit. In our example, 1.34885 times $60,000 equals $80,931.
Repeat the steps substituting a shorter number of times the interest compounds over the investment's entire life. In our example, if the investment compounded only over three years, then its value is $71,800.86. Therefore, by investing in the account two years earlier with the same amount of money, the investor will have made more than an extra $9,000 due to compounding.
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