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The interest rate stated on your investment prospectus or loan agreement is an annual rate. If your car loan, for example, is a 6% loan, you pay 6% interest each year. Compounding once at the end of the year is the easiest calculation for compounding interest. A debt may compound interest annually, monthly or even daily. The more frequently your debt compounds, the faster you will accumulate interest. You can look at compound interest from the investor or the debtor's point of view. Frequent compounding means that the investor's interest earnings will increase at a faster rate. It also means that the debtor will owe more interest while the debt is outstanding. For example, a savings account may be compounded annually, while a pay-day loan can be compounded monthly or even weekly. Assume that you own a $1,000, 6% savings bond issued by the US Treasury. Treasury savings bonds pay out interest each year based on their interest rate and current value. Interest paid in year 1 would be $60 ($1,000 multiplied by 6% = $60). To calculate interest for year 2, you need to add the original principal amount to all interest earned to date. In this case, the principal for year 2 would be ($1,000 + $60 = $1,060). The value of the bond is now $1,060 and the interest payment will be calculated from this value. To see the bigger impact of compound interest, compute interest for later years. As you move from year to year, the principal amount continues to grow. Multiply the year 2 principal amount by the bond's interest rate. ($1,060 X 6% = $63.60). The interest earned is higher by $3.60 ($63.60 - $60.00). That's because the principal amount increased from $1,000 to $1,060. For year 3, the principal amount is ($1,060 + $63.60 = $1,123.60). The interest earned in year 3 is $67.42. That amount is added to the principal balance for the year 4 calculation. The longer a debt is outstanding, the bigger the impact of compounding interest. Outstanding means that the debt is still owed by the debtor. Without compounding, the year 2 interest would simply be ($1,000 X 6% = $60). In fact, every year's interest earned would be $60 if you did earn compound interest. This is known as simple interest. It can be handy to visualize compound interest by creating a simple model in excel that shows the growth of your investment. Start by opening a document and labeling the top cell in columns A, B, and C "Year," "Value," and "Interest Earned," respectively. Enter the years (0-5) in cells A2 to A7. Enter your principal in cell B2. For example, imagine you are started with $1,000. Input 1000. In cell B3, type "=B2*1.06" and press enter. This means that your interest is being compounded annually at 6% (0.06). Click on the lower right corner of cell B3 and drag the formula down to cell B7. The numbers will fill in appropriately. Place a 0 in cell C2. In cell C3, type "=B3-B$2" and press enter. This should give you the difference between the values in cell B3 and B2, which represents the interest earned. Click on the lower right corner of cell C3 and drag the formula down to cell C7. The values will fill themselves in. Continue this process to replicate the process for as many years as you want to track. You can also easily change values for principal and interest rate by altering the formulas used and cell contents.
Define annual compounding. Calculate interest compounding annually for year one. Compute interest compounding for later years. Create an excel document to compute compound interest.