Compound interest is an important concept for any investor to understand. It truly can work wonders for your long-term gains if you understand its fundamental operation. Compounding interest involves adding the interest earned to your initial investment, so that the interest itself earns interest. You can calculate compound interest using an equation with four essential factors.
To calculate what your investment will be worth in the future with a certain rate of compound interest, you begin with its present value. This is expressed as "PV" in the equation. It's also often referred to as the initial investment.
The rate of interest you will earn on your investment is the next factor you need to know to perform your calculation. This is termed "i" in the equation. Of course, in a real-world situation, this often varies significantly over time, which is what makes investment formulas so complex and the outcome uncertain.
If you are adding interest back to your initial investment in order for it also to earn interest, you need to know how often this is going to happen. This is known as the compounding period. In a real-world situation this can be annually, monthly or, occasionally, daily. In the equation you need to know the number of these compounding periods, expressed as "N".
The last factor needed for the equation is the final value or "FV", which is the value of the investment after compounding at the rate "i" for the number of periods "N". Thus the equation to calculate compound interest is expressed: PV x (1+i) ^N = FV
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