What is compound interest?
Compound interest, also known as compound interest, is interest that is calculated based on the original principal amount of a deposit or loan and on all interest accrued previously.
For example, let’s say that $ 100 represents the principal of a loan that carries a cumulative interest rate of 10%. After one year you have $ 100 in principal and $ 10 in interest, for a total basis of $ 110. In the second year the interest (10%) is applied to the principal ($ 100, resulting in $ 10 interest) and the interest collected ($ 10, resulting in $ 1 interest), for a total of $ 11 in interest earned that year. The second-year increase is $ 11, instead of $ 10, because interest is compounded – that is, it is applied on a larger basis ($ 110 compared to $ 100, our starting point). Every year the basis increases by 10%: $ 110 after the first year, then $ 121 after the second year.
What is the compound interest formula?
It is comparable to the compound annual growth rate (CAGR). For CAGR you calculate a rate that links the return over a number of periods. For compound interest you probably already know Rostov familyijk the rate; you simply calculate what the future value of the return could be.
For the compound interest formula, you can simply redistribute the CAGR formula algebraically. You need the initial value, the interest rate and the number of periods in years. The interest rate and the number of periods must be expressed in annual periods, since the length is assumed to be in years. From there you can solve the future value. The comparison is:
Initial value * (1 + (interest rate / number of compounding periods per year)) ^ (year * number of compounding periods per year) = Future value
This formula looks more complicated than it really is, because of the requirement to express it in annual terms. Bear in mind that if it is an annual percentage, the number of compounding periods per year is the same, which means that you divide the interest rate by one and multiply the years by one. If the aggregation takes place quarterly, divide the rate by four and multiply the years by four.
Calculate compound interest in Excel
The best practices for financial modeling require that calculations are transparent and easily verifiable. The problem with stacking all calculations in a single formula is that you cannot easily see which numbers go where or which numbers are user input or hard codes.
There are two ways to set this in Excel. The easiest way to check and understand is to have all the data in one table and then to break down the calculations line by line. Conversely, you can calculate the entire equation in one cell to get only the final value. We recommend the first approach, but both are described below.