Compound interest is the interest which is earned both on the original investment (the principal amount) and the total interest accumulated so far. Here are a few methods to calculate compound interest.
Method 1
This method is suitable for interests which are compounding annually or whose duration is just a few years. Suppose the annual compound interest rate is 7% (0.07) on a $1000 investment for 3 years. Then
Interest for first year: $1000 x 0.07 = $70, Total amount: $1070
Interest for second year: $1070 x 0.07 = $74.9, Total amount: $1144.9
Interest for third year: $1144.9 x 0.07 = $80.14, Total amount: $1225.04
So the total amount of interest will be: $70 + $74.9 + $80.14 = $225.04
Method 2
Suppose an interest is compounding more frequently like quarterly, monthly or weekly or spread over a duration of many years, it is more convenient to use the compound interest calculation formula:
FV = P (1 + i/c)n*c
where
FV = Future value of the principal
P: Principal amount
i: Interest rate
c: Compounding frequency per year
n: Number of years
Suppose the interest rate is 5% (0.05) compounding quarterly on a $1000 debt taken for 5 years, then
P=$1000, i=0.05, c=4, n=5
FV = P (1 + i/c)n*c = $1000 x (1 + 0.05/4)5*4 = $1000 x (1.0125)20 = $1000 x 1.282 = $1282
The future value will be $1282 after 5 years.
The compound interest will be $1282 - $1000 = $282
